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Good morning, ladies and gentlemen. Welcome to the second quarter results conference call. I would now like to turn the meeting over to Tom Mullane. Please go ahead.
Yes. Thank you very much. Good morning, ladies and gentlemen. Welcome to the Freehold Royalties Ltd. 2020 Second Quarter Conference Call. Thank you for joining us. With me on the call from Freehold are Dave Hendry, our CFO; Dave Spyker, our COO; Rob King, our Vice President of Business Development; and Matt Donohue, our Manager of Investor Relations and Capital Markets.Before we get into the highlights for the quarter, we want to note that alongside government and public health officials, we are actively monitoring COVID-19 updates and following the latest guidance. In the initial phase of the COVID-19 pandemic, we prioritized the health and safety of our workers by directing all workers to work from home. As Alberta 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. With this preparation, we were able to reopen our office in July with a reduced staff complement. We will continue to monitor COVID-19 updates and follow the latest guidance to move to the next phase of return. We appreciate the continued efforts of our staff during this time and want to thank shareholders for their ongoing support. Operationally, the second quarter was challenging with demand weakness for commodities associated with COVID-19, coupled with a supply battle within OPEC, driving global crude prices to multi-decade lows. As a result of this weakness, we saw a number of producers on our royalty lands shut in production in order to preserve economics and reserves. Royalty production for the quarter on Freehold lands averaged 9,150 BOEs a day, down from 10,618 BOEs a day the previous quarter and 10,311 BOEs a day during the same period in 2019.On a positive note, this period of weakness is behind us for Freehold shut-in volumes reached a peak of 20% of total production in May but averaged 11% for the quarter. Through the remainder of the year, we see volumes improving in core areas like Clearwater, Viking, Southeast and Southwest Saskatchewan and North Dakota. This is driven by volumes going back online and the resumption of third-party drilling on our royalty lands.As mentioned, the lower prices had a material impact on drilling activity on our lands with no wells drilled during the second quarter. Drilling through the first half of 2020 has totaled 229 gross, 6.6 net wells, down approximately 35% versus the same period last year. Looking into the second half of 2020, we do expect some activity in our royalty lands driven by traditional payers with incremental dollars spent on plays in Southeast and Southwest Saskatchewan and Central Alberta.Given the backdrop for shut-in volumes and uncertainty around the pace of third-party drilling, Freehold announced early in the quarter its previously released 2020 guidance was no longer applicable. We're continuing to suspend guidance at this time with the expectation we will resume guidance with the return of clarity and stability associated with the commodity price environment and our royalty payers drilling programs.During the quarter, reflecting sustained weakness in crude oil prices, Freehold's Board of Directors revised Freehold's monthly dividend rate from $0.0525 to $0.015 per common share. At revised monthly dividend level, Freehold's funds from operations are forecast to exceed dividend outflows for the remainder of 2020 and be at the low end of our annual payout range of 60% to 80% for 2020. Adjusting the dividends during the quarter preserved the strength of our balance sheet and enhances our ability to pursue value-enhancing acquisitions. Looking forward, we expect to pay down debt levels in the near-term with the expectation to revise the dividend as our forecast for funds from operations improves. At current commodity prices, we expect to pay down approximately $3 million to $3.5 million in debt per month. Although debt levels are expected to stay flat in the third quarter over second quarter, as we account for the $11.5 million deposit to the Canada Revenue Agency, which Dave Hendry will speak about shortly. In addition, our Board of Directors and staff reduced G&A by approximately 15%, which we believe was important to align with our shareholders' experience. Lastly on April 30, 2020, Freehold disposed of certain working interest properties with estimated production of 265 BOEs a day. As part of the agreement, the purchaser has agreed to assume the decommissioning liabilities of approximately $3.6 million on these properties. The benefits of this disposition include a material improvement in operating costs moving forward and reduced spending associated with asset retirement obligations associated with these assets.Now I'll pass the call to David to walk through some of the financials.
Thanks, Tom. And good morning, everyone. Financially, while we endured a significant retreat in global oil prices over the second quarter, Freehold continues to provide a meaningful dividend which has differentiated ourselves from many traditional E&P companies in Canada over the period.In the second quarter, Freehold generated $14.8 million in royalty and other revenue, down 58% versus the same period in 2019, reflecting lower liquid prices and lower production, slightly offset by improved natural gas pricing. Total royalty revenue was comprised of 75% oil and NGLs, which also reflected the decline in oil prices. Our royalty portfolio generated an operating netback of $16.86 per BOE in the second quarter, a 52% decline versus the same period in 2019, which mirrored the 53% decline in WTI prices during the same period.Funds flow from operations for Q2 2020 totaled $10.6 million, down 65% from Q2 2019 levels. Our payout on a dividend paid basis totaled 92% in the second quarter of 2020, up from 62% during the same period in 2019. At the revised dividend level, we target Freehold's payout to remain at the low end of our outlined range of 60% to 80% for 2020. Through the remainder of the year, we expect Freehold's payout to remain below 40% on a declared and paid basis. Cash costs for the quarter totaled $4.79 per BOE, down from $5.06 per BOE during the same period in 2019. The decrease year-over-year reflects lower operating and financing charges. The reduction in cash cost was most materially impacted by the disposition of working interest production over the quarter. Freehold closed the quarter with a $5.7 million reduction in net debt from Q1 2020. Net debt totaled $96 million at June 30, 2020, representing 1.1x net debt to funds flow from operations. The decrease in net debt quarter-over-quarter reflected the reduction in dividend obligations, the disposition of our working interest assets and resulting lower asset retirement obligations, offset by weaker production, resulting in lower funds from operations.Even though oil prices are likely to remain subdued through 2020, we expect our long-term debt-to-EBITDA ratio to remain covenant compliant. Freehold's prudent strategy of maintaining long-term debt to cash flow below 1.5x and a dividend payout range of 60% to 80% of funds flow from operations provides cushion for volatile prices. Freehold incurred a second quarter 2020 net loss of $5.8 million compared with a $3.4 million net income recorded during the same period in 2019. The higher net loss reflected lower revenues due to the retreating oil prices and lower production volumes. During the quarter, Freehold announced that it had received a proposal letter from Canada Revenue Agency. Freehold has now received notices of reassessment from the CRA, in which the CRA has denied the deduction of certain noncapital losses and other tax attributes in computing the company's income for taxation years ending in 2015 and 2018. In order to appeal these reassessments, Freehold is required to make a payment of 50% of the reassessment amounts, $11.5 million, as a deposit to the CRA prior to September 1, 2020.Freehold has received legal advice that it is entitled to deduct the noncapital losses, and as such, management remains of the opinion that all tax filings to date are filed correctly. And that it expects to be successful in its objection of these reassessments, and therefore, any future deposits paid to the CRA should be refunded plus interest. Freehold anticipates the proceedings through the CRA could take a year or more to resolve. Further, the payment of any deposits does not impact Freehold's earnings or funds from operations. Freehold is currently in the process of filing its objection of the reassessments. Now back to Tom for his final remarks.
Thanks, Dave. Looking forward, we expect the next 3 to 6 months to remain challenging for the industry, although improving sharply from oil price lows of Q2. Setting ourselves apart, Freehold provides investors relative stability as royalties represent a higher-margin business, as we do not pay typical costs associated with oil and gas operations and reclamation, enabling more returns to be transferred to our shareholders.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. As we allocate free cash flow, our preference is to ensure sustainable dividends while maintaining a conservative balance sheet with the medium-term outlook shifting to value creation via acquisitions as we grow and improve our royalty portfolio.The ability to access capital, both equity and debt, remains challenged for many E&P producers, and we believe we can serve as a financing tool through the creation of new royalties in core play areas in Canada and in the United States. The royalty model is sustainable through all commodity cycles, as we have demonstrated since we went public in 1996, nearly 25 years ago.Now we would entertain any questions.
[Operator Instructions] The first question is from Amir Arif.
Just a couple of quick questions for you here. Just first of all, on the -- like in terms of the shut-in volumes, are you -- we've noticed that some of the processing companies and gathering companies are having to provide some incentives to bring some shut-in volumes back online. Just curious if you're having to do anything on the royalty front to incentivize some of the shut-in volumes to come back or maybe the drilling to start?
Thanks, Amir. It's Rob King speaking. No, we haven't had any of those -- any material discussions in that regard. Certainly, when I think back to the April-May time period, as companies were shutting in volumes, we had a lot of discussions about how or if we may be able to work with them on the royalty rate to think about whether we -- they continue to shut in or not, and the reality is we didn't make many changes at all back then. And as volumes have come back online, we similarly have not seen anything material from our royalty payers in terms of needing to modify the royalty rate.
Okay. And then just secondly, I know in your remarks, you did mention that you've seen activities coming back in Clearwater, Viking and Saskatchewan. Just curious with the improvement in the gas strip, have you seen any pickup in interest in terms of gas drilling on any of your acreage?
We've had a little bit of activity on the gas side, I would say. If you think back to our 2019 and Q1 of 2020 drilling activity, well over 90% was focused on oil. And so while we -- 40% of our production base is natural gas, the reality is most of our drilling activity has been and we expect will continue to be on the oil side.That being said, we had a few wells that have been drilled in the -- probably about half a dozen by the end of the year we expect in the Deep Basin. So there are some -- there certainly is some gas drilling activity on our land. But for the most part, those plays that you mentioned are where we anticipate seeing the bulk of the activity in the back half of the year here.
Okay. And then just on the dividends. I know you've got your 60% to 80% payout ratio range and 1.5 for your leverage metric that you'd like to get to. Like how many quarters below those levels would you need to see before you're comfortable bringing some of that dividend cut back into the dividend or bringing the dividend back up, I would say?
Yes. Thanks, Amir. It's Tom. As far as our dividends go, I mean, we revisit our dividends with our Board every quarter and give them a forecast outlook. When we look at 2020, with our payout being at the low 60s within our range, and also the cash flow near the upper end, where we're comfortable, we're not -- we'll probably -- we're going to revisit in our third quarter release here -- later this year on the timing of perhaps increasing our dividend or adjusting our dividend according to the conditions at the time. So we'll revisit that in November with our release of our third quarter. But Amir, just we're at the lower end for the year. And on a -- I guess, on the -- as we mentioned here, below 40% payout in the back half, but on average, within our target range for the year for 2020. But certainly, we are below that right now.
And just one final question. We've seen a pickup in industry M&A and A&D activity out there. And historically, some companies have used royalties or putting a royalty on some of that acquisition as a financing vehicle. Just curious if you can give us any color on what you are seeing on that front or if any?
Yes. I mean, I think, in terms of Q2 activity, it was pretty quiet. Like we had a -- I would characterize it as a modest level of discussions, both in Canada as well as in the U.S. that has definitely picked up in July and August, particularly in the U.S. but also in Canada with a lot more marketed deals as well as proactive discussions. I would say it is a -- it's a really tough environment for a lot of companies and a lot of companies do need money, and we're being fairly discerning in this environment in terms of what we're looking at and what our return thresholds need to be, and looking at ways that we can continue to even add even better quality assets to the portfolio.
The following question is from Luke Davis.
I'm just wondering if you can comment a little bit more on M&A and whether or not you're having issues finding counterparties that you think are viable and can be able to provide drilling commitments that actually makes sense to you longer term?
Yes. Good. It's a good question, Luke, and that's certainly -- you're kind of hitting the nail on the head in terms of one of the key aspects in terms of being able to bridge that bid-ask spread with the potential counterparties, in terms of -- clearly, a lot of the deals we're looking at right now have a higher than we would have had average PDP weighting in the value that we're coming up with because it is the -- while there still is clearly upside in a lot of the opportunities that we're looking at, the funding ability and when those upside locations will be drilled certainly gets pushed out. So that kind of comes back to that comment on being more discerning in the quality of the asset and the quality of the counterparty in terms of having some confidence in terms of that they're going to be able to drill.And that kind of comes into some of the structuring that we've been talking to people about as well in terms of ring-fencing some of the consideration, with not just to debt repayment on their part, but also to putting it into the ground, so we can more fully ascribe value to those undeveloped locations.
Right. That makes sense. Okay. And then just wondering on the CRA proposal. If you guys -- like assuming you guys aren't treating anything differently here, so I'm wondering if you can kind of quantify what the downside risk is for the out years, maybe 2019 and 2020, assuming that, that comes back and it's not in your favor?
Yes, it's Dave Hendry here. So as far -- first of all, it's not uncommon for a reassessment auditor to do this. So we still very strongly believe that our position is correct, and we fully believe that we'll get the reassessment. For context, we did file our 2019 tax year, and we did apply $22 million of capital losses to that. So for -- I think it was for about a $6 million cash -- or for a tax effect of it. So that gives you a bit of a context for how that applied for 2019. But we obviously just have to wait until an appeals officer gets assigned to our case. And that's why it takes like upwards of a year. It's not the complexity or any concerns with regards to our case. It's just a matter of getting through the queue until our term -- or our time is up to resolve the issue.
[Operator Instructions] The following question is from Adam Gill.
Just in terms of where the opportunities are, are producers with better balance sheets open to discussions? Or do you find the guys that are more open to discussions are the guys with a weaker financial position?
Yes. I'd sort of say, Adam, it's a bit of both, to be frank. I think there certainly is -- if you were to probably -- if you had to put it into a percentage category, I think it probably would be a higher percentage of companies that are maybe in a more challenged liquidity leverage perspective that are kind of actively looking at the GORR side. But there are other better capitalized companies that are considering that as an alternative given the lack of availability of other capital, both in the bank and equity market. I'd sort of say a meaningful part of our U.S. opportunity focus is on the mineral title side. So that's certainly less relevant in that regard.
There are no further questions registered at this time. I'll turn the meeting back over to Mr. Mullane.
Yes. Thank you very much. Thank you, everybody, for joining us on this conference call. Obviously, this is a challenging time. One of the things that you will see in the royalty space is that this model is pretty resilient through all commodity cycles. And we will continue to provide our shareholders with a return of capital, primarily in dividends. And as cash flow improves, our dividend will improve. Thank you very much for joining us.
Thank you. The conference has now ended. Please disconnect your lines at this time. We thank you for your participation.