This Oil Deal Is Protected on the Downside

Franco-Nevada Corporation (NYSE: FNV) is a gold and silver streaming and royalty company. It differentiates itself from precious metals peers like Royal Gold and Wheaton Precious Metals by building a highly diversified portfolio. That includes assets outside of the precious metals space. Its latest nonmetal diversification effort, meanwhile, shows just how focused Franco-Nevada is on living up to one of its key goals: safety. Here's what you need to know.

Putting safety first

Franco-Nevada Chairman Pierre Lassonde and CEO David Harquail summed up the precious metals streaming company's approach in the 2017 annual report like this: "Our aspiration is to make Franco-Nevada the 'go to' gold stock for any generalist investor. We believe that our emphasis on paying dividends, avoiding debt, minimizing risk through a diversified royalty and stream portfolio and maintaining high governance standards is what generalist investors want."

This safety-first approach has served investors well, with 10 consecutive years of annual dividend increases backed by a debt-free balance sheet. And while gold made up roughly two-thirds of revenue in the second quarter, Franco-Nevada's diversification goes beyond simply investing in a large number of mines (295 at last count). It also generated around 11% of revenue from silver, 6% from other metals, and roughly 14% from oil and natural gas. None of its major peers have this level of diversification, notably because of the energy component.

Opportunistically speaking

Franco-Nevada used the mid-2014 downturn to materially ramp up its investment in the oil and natural gas space. It was a good move, since the company was able to take advantage of low prices while building that position. The benefit has been on display this year, with weakness on the precious metals side of the company through the first half of 2018 being largely offset by expansion in the energy business. To put some numbers on that, precious metals revenue was down $14 million year over year (off about 9%) and oil and natural gas revenue was up $13 million (advancing an impressive 135% or so).

Oil prices are higher today than they were just a couple of years ago, after starting to rebound in early 2016. So it isn't as easy to find the kinds of deals Franco-Nevada was inking not too long ago. But Franco-Nevada still sees value in the energy space -- if the right deal is available. For example, it just partnered up with Continental Resources, Inc. (NYSE: CLR).

The agreement here provides for the up-front purchase of $220 million of mineral rights for land that Continental owns, with revenue expected to start showing up in 2019. Continental plans to use that cash to help fund its capital spending plans. The two will partner on future deals over the next three years as well, with the expectation that Franco-Nevada will invest $100 million per year.

The key here, however, is the clarity provided by this partnership -- Continental is making the call on what mineral rights to buy based on land it knows it wants to drill. So instead of buying mineral rights and hoping that someone comes along to put holes in the ground, Franco-Nevada is buying land that it knows is highly likely to be drilled. Safety-first on clear display, but it gets even better.

The agreement calls for Franco-Nevada to get a minimum of 50% of the revenue generated from the drilling activity. Continental receives a minimum of 25%, and the last 25% is variable. If Continental is highly successful in its production efforts, it can earn the remaining 25%. If not, Franco-Nevada will get all of it. The final mix of that variable 25% depends entirely on successful execution. That incentivizes Continental and, even if it gets the full 25%, Franco-Nevada still wins because its 50% will be roughly the same as it would have been if volumes had fallen short of expectations. Either way, Franco-Nevada gets the revenue it is using in its projections for the investment.

Not your ordinary gold streaming company

Franco-Nevada goes about the streaming business a little differently than its peers. A key piece of that is diversification, which includes both a larger portfolio of mines than peers' and the exposure to oil and natural gas, adding notable commodity diversification. But the Continental deal really shows how focused Franco-Nevada is on safety, by taking a unique approach to the energy space and building a relationship that helps ensure the mineral rights it owns are put into play. And that's further backed by downside protection if Continental's production results fall short of expectations. If you are looking for a royalty company, Franco-Nevada should be on your short list.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.