BP Prudhoe Bay Royalty Trust (BPT) annually updates its calculation of future cash flows likely to be generated by the Trust based upon certain assumptions. It reports this number in its annual report/ 10K, which will be issued in a few weeks. (Last year's report was filed in early March.) I believe this number will show a decrease in future cash flows on an un-discounted basis of at least $250 million from last year's figure of $2.460 billion, and a decrease in future discounted cash flows of about $150 million from last year's figure of $1.433 billion.
To understand how I arrived at this figure, it is important to first understand how BP Prudhoe Bay's accountants calculate these numbers.
The first and most significant element in the calculation is the profit per barrel generated by the Trust. The accountants begin with the average price per barrel, determined using the price on the first trading day of each month. They then assume that for the life of the Trust there will be no increase in the price of oil nor any inflation affecting the Adjusted Chargeable cost calculation. Using this data from 2011, a graph of net revenue per barrel to the Trust, prior to deducting production taxes or Trust expenses is as follows:
The area between the lines represents the cumulative lifetime revenue (pre-tax) per barrel of annual production. To arrive at the total "future cash inflows" for the Trust, this needs to be multiplied by projected production each year, which is how the $2.46 billion figure in the 2011 10K was arrived at. Dividing this number by the 21.4 million trust units outstanding resulted in an un-discounted cash flow per unit of $115, and using the discounted figure of $1.433 billion, results in a discounted value per unit of $67/unit.
Although the 2011 10 K indicates that the Trust will generate cash "through 2027" the above graph indicates that the Trust will actually generate cash through 2030. It does not take into account administrative expenses, which would cause a slightly earlier termination. They are currently a relatively insignificant $1.5 million per year (although they have increased about 10%/ year. the last two years.) As the Trust cash flows diminish toward the end of its life, these amounts start to become more significant. It is also possible the accountants provided a slightly conservative final termination date.
I realize these numbers are not a realistic representation of the likely cash flows for the units, but all I am trying to do at this point is project the figures to be reported in the 2012 10K, using the company's methodology. Each year, when this estimate is updated in the 10K, the company takes into account the fact that one more year of the Trust's life has passed, along with updates to oil prices, costs and projected production.
The first adjustment that needs to be made is to subtract what the company had projected for 2012. The payment of $2.51 made in Jan. 2012 for the 4th quarter of 2011 is a good proxy for this. I presume the company was estimating 90,000 barrels per day this year since all recent quarters, including this one, (except for the 3rd quarter when production was affected by maintenance) were at this level. The price per barrel in the 4th quarter of 2011 was $93.92, only slightly less than the $96.19 used in the projections, so I would estimate that the total the company projected for the year was a bit over $10 (2.51 x 4). Deducting this $10 from the ye 2011 figure reduces the future cash flows to $105.
The second adjustment that needs to be made is to adjust the cost curve up in the projections, since they assume a 0% increase in the CPI, whereas the CPI actually increased by 1.75% last year.
Although it is a bit difficult to see on the above graph, the increase in last year's CPI causes a minor increase in the entire cost curve, ranging from $.50 per barrel this year to about $2 per barrel in 2030. This will cause an estimated further decrease of $1-1.50 in the projected cash flow/unit to $103-104/unit.
The final change is to update the projected WTI price based upon the average WTI on the first day of each month in 2012. One source of this information is as follows:
The average price for 2012, using the same methodology as BPT's accountants (the first business day of each month) results in an average of $95.29, or $.90 less than the average in 2011. This will reduce the gross cash flow by another $2 or so per unit, reducing my estimate to roughly $101-102. This results in un-discounted cash flows a bit under $2.2 billion, or a reduction of at least $260 million from the figure reported in the 2011 10 K. Discounting this figure at the 10% rate used by BPT's accountants, results in a discounted value of less than $1.3 billion, a decrease of roughly $150 million, or about $7/unit, to about $60/unit.
I know that at this point, many readers are thinking that these numbers are useless because they are based upon unrealistic assumptions of no increase in oil prices and no inflation. However, if projections are done based upon a more realistic expectation of increases in both of these numbers, it turns out that these numbers are a somewhat conservative, but not totally unrealistic estimate of future cash flows. Assuming a 3% increase in both oil prices and CPI results in a graphical representation as follows:
Surprisingly, the termination date of the Trust, when the two curves intersect, is only extended by a few months. Also, the area between the curves, which represents total income prior to termination, is only modestly greater. It appears to add about $15-$20 un-discounted and roughly $10/ unit on a discounted basis, which would value the units at about $70 each.
One other issue highlighted by some of the above analysis is that a significant portion of each payment is a return of capital. The units will ultimately decrease to zero at termination and will generate roughly $120 gross prior to then. Since the units are trading at close to $80 each, this means that 2/3 (80/120) of the payments need to be considered a return of capital and only 1/3 as income. Even an oil price "bull" who might expect the Trust to generate $160 of total payments prior to termination would have to consider at least half of the distributions to be a return of capital. These figures are consistent with the tax reporting package, which indicated the appropriate depletion rate to use last year was almost 6%, a rate which will increase each year as termination approaches. Using the current price of $80, results in depletion of about $5. Since the Trust paid out $9.08 in the past 4 quarters, this suggests that only $4 or so of this amount was income, the rest being return of capital. In other words, the current yield on the trust is about 5%.
There also appears to be confusion among some investors as to why BPT has been able to make significant upward revisions in projected future cash flows in some prior years. There have been attempts to link this to the discussion of additional proved reserves in the company's 10 K's, whereas it is mainly due to a significant increase in oil prices during the preceding year. The increase between 2010 and 2011 is an ideal case in point, which can be graphically represented as follows:
As this graph makes clear, the increase in cash flows is due to the increase in oil prices, as represented by the area between the 2010 and 2011 oil price lines (less the cash that had been projected to be received during 2011). It also demonstrates why the projected termination of the Trust was extended by a few years. The WTI price and cost lines simply intersect at a different point. Barring another 21% increase in oil prices in a single year, situations like this are unlikely to occur in the future. The only significance of an increase in the proven reserve figure in the company's financials is that it suggests the rate of decrease in production may be a bit less than previously projected.
Disclosure: I am short BPT.