I believe that BP Prudhoe Bay Royalty Trust (NYSE:BPT) can be more accurately described as a derivative security, rather than a royalty trust, since its value is not directly related to the profitability of the Prudhoe Bay oil fields, but rather some artificial constructs only tangentially related to the economics of the oil field. Furthermore, it is constructed such that its cash flows will start to diminish appreciably commencing in 2018. Under the wrong circumstances, mainly a higher general inflation rate than nominal increases in oil prices, the Trust could terminate a number of years earlier than the current projection of 2027.
The math for calculating the quarterly distributions is quite simple and most of the information is pre-determined and/or publicly available. It is based upon the following elements, although I will focus only on the first two, which are the most significant:
- The WTI price/barrel
- The Adjusted Chargeable Cost per barrel
- Production "taxes" per barrel
- Prudhoe Bay production
The WTI price has no direct relationship to the revenue actually generated by a barrel of oil from Prudhoe Bay. Currently the price happens to be much closer to the price of Brent, roughly $15/barrel higher, and the owners of BPT reap none of this benefit. This is the first indication that the BP Prudhoe Bay unit holders do not have a true economic interest in its proportionate share of the oil in the Prudhoe bay field.
The Adjusted Chargeable Cost per barrel for the Trust has absolutely no relationship to the actual cost of producing a barrel of oil at Prudhoe Bay, which might be higher or lower than what the Trust is charged. It is a completely artificial calculation, and one that will have an increasingly negative impact upon the cash flows of the Trust beginning about 2018. The Chargeable Cost calculation, along with the actual numbers for the January and April 2011 quarters, when there was an unusually large Chargeable Cost increase, as disclosed in the Sept. 30, 2012 10Q, are as follows:
Cost Adjustment Factor
Adjusted Chargeable Cost
The math to calculate the Adjusted Chargeable Cost is the same as to calculate the area of a rectangle; when both "sides" increase modestly, (in this case the Chargeable Cost and the Cost Adjustment Factor), the "area" (in this case, Adjusted Chargeable Cost) increases by a more substantial percentage than either component.
Chargeable Costs in each future calendar year are disclosed in the 2011 10K. For the next few years, the Chargeable Cost increases by a very modest $0.10/yr. However, starting in 2018, it begins to increase dramatically; in that year it increases by $2.80, and in most years thereafter, it increases by $2.75/yr. This implies a much larger annual increase in the Adjusted Chargeable Cost that the Trust pays. If inflation continues at a 1-2% pace, the Cost Adjustment Factor in 2017 will be at least 2. As a result, the Adjusted Chargeable Cost will be at least $34.40 in that year, and even if there is no inflation in that particular year, the cost will go up by at least $5.60 (2.80 x 2) the following year. However, if inflation is 3% that year, here is the impact:
Cost Adjustment Factor
Adjusted Chargeable Cost
As the table demonstrates, a very modest CPI increase of 3% causes the Adjusted Chargeable Cost to increase by $6.80 rather than $5.60 in a single year, a 21% increase over what the increase would have been if there had been zero inflation. This impact becomes more pronounced with each passing year as "both sides of the rectangle" increase.
I suspect the annual increase in Chargeable Cost by an unusually large $2.10 in 2011, may have been meant to be a sort of "warning flag" for Trust holders to demonstrate how the math works. During the next few years, there are minimal increases before it consistently begins to increase rapidly. These rapid increases appear to be a method to ensure that the Trust ultimately terminates, even though there is no formal termination date.
The estimate contained in the 2011 10K that the Trust will terminate in 2027 (p. 19) assumes no inflation, as measured by the CPI, and no increase in oil prices between now and then. The Trust's Adjusted Chargeable Cost simply reaches the $96.13 price/bl. that was used in the 2011 projections (2011 10K, p. 48) and therefore there is no longer a spread for Trust owners beginning in that year. If there is 3% inflation every year between now and 2027, then Adjusted Chargeable Costs would be roughly $135 in that year. If oil prices also increase at 3%/yr., both the price of oil and the Adjusted Chargeable Cost would be around $150 in 2028, resulting in no net revenue to the Trust holders, so there would only be one additional year before the Trust terminates and my rough estimate is that the cumulative cash flow would only be $10-20/unit higher.
Under a downside scenario of no increase in oil prices, and 3% inflation, the Trust would terminate about 2022 by my calculations, and total payments to Trust holders would only be $60 or so.
I have read a number of comments on this site where the authors have been trying to project how long the Prudhoe Bay field will continue to produce oil economically. Even if BP Alaska is able to produce oil profitably for the next 100 years, it appears that none of this benefit will accrue to the Trust holders once the Adjusted Chargeable Cost reaches the WTI price/bl., in line with my thesis that BP Prudhoe Bay is basically a derivative. In fact, the 2011 10K (p. 19) states "It is estimated that royalty payments to the Trust will continue through the year 2027. BP Alaska expects continued economic production from the Prudhoe Bay field at a declining rate after that year; however, for the economic conditions and production forecast as of December 31, 2011, the Per Barrel Royalty will be zero following the year 2027."
I have also seen articles where the authors believe the price of oil will increase faster than the increase in the CPI, and as a result, an investment in BP Prudhoe Bay will be a profitable one. I do not disagree with the math. However, if the price of oil does increase at this rate, most exploration and production companies would most probably be much better investments. With these companies, the investor would be buying a piece of an operating company and would share in the economics of rising oil prices, without being handicapped by artificial and rapidly increasing "Adjusted Chargeable Costs."
Additional disclosure: I had been long BPT, but after trying to understand why the price decreased so rapidly last year, I took the advice contained in one of the Seeking Alpha articles and did a spreadsheet. As a result, I believe the company may still be somewhat over valued and am now short the stock, mainly via options. I am a former employee of The Bank of New York (now The Bank of New York Mellon), the Trustee for BPT, but I left over 12 years ago, never worked in the Corporate Trust area and do not have "inside information" of any type regarding this security.