ECA Marcellus Trust I (ECT) is a Delaware statutory trust formed in March 2010 by Energy Corporation of America (ECA). The royalty trust conveyed a 90% proceeds interest in 14 PDP ("Producing Wells") horizontal natural gas wells producing from the Marcellus Shale formation. Additionally, the trust conveyed a 50% proceeds interest in 52 horizontal natural gas development wells ("PUD Wells") in which drilling was completed ahead of schedule before March 31, 2013. ECA presently holds approximately 9,300 acres, of which it owns substantially all of the working interests, in Greene County, Pennsylvania.
On March 31, 2010 and after giving effect to the conveyance of the PDP Royalty Interest and the PUD Royalty Interest, the total gas reserves estimated to be attributable to the trust interests were 108.6 Bcf. This amount includes 73.5 Bcf attributable to the PUD Royalty Interest and 35.1 Bcf attributable to the PDP Royalty Interest.
The trust makes quarterly cash distributions of substantially all of its cash receipts. The first distribution was made in August 2010. It is important for investors to understand that the trust will liquidate on the Termination Date of March 31, 2030. At the Termination Date, 50% of each of the PDP Royalty Interest and the PUD Royalty Interest will revert automatically to ECA. The remaining 50% of each of the PDP Royalty Interest and the PUD Royalty Interest will be sold, and the net proceeds will be distributed pro rata to the unit holders soon after the Termination Date. ECA will have a right of first refusal to purchase the remaining 50% of the royalty interests at the Termination Date.
Another important issue for investors in ECT and similar U.S. based Royalty Trusts is that distributions by the trust are generated by depleting assets and the trust has a finite life with the production from the underlying properties diminishing over time. A portion of each distribution represents a return of the original investment. An investor must assess what the remaining interests will be worth when the trust is terminated. The IPO prospectus projected $2.81 per share assuming natural gas prices are at $9 per MMBtu cap starting in 2027.
Trust Market Statistics
ECT launched its IPO on 7/1/2010 at a price of $20 per share. Currently, the unit holder traded price per share is $18.34 as of market close on 2/26/2013. ECT is a pure play on natural gas because it is 100% natural gas volume production.
On 2/7/2013, the trust published an 8-K which reported that estimated net reserves attributable to the royalty interest held by the trust to be 68.5 Bcf, and estimated the discounted future net revenues attributable to the royalty interest held by the trust, discounted at 10% annually and using average prices during the 12-month period prior to December 31, 2012 in accordance with SEC regulations, at $79.1 million. The average price used was $2.88 per thousand cubic feet of natural gas.
Based on the production since the IPO and the 8-K publication, the trust is estimated to have depleted 23.2% of its proven reserves as of 12/31/2012.
The IPO prospectus published a target distribution level which it set as a goal (not guaranteed) which the sellers of the trust assets projected as a reasonable return that an investor in the trust might expect to receive for the sale of the natural gas reserves held by the trust over time. The total target distributions projected were $39.21 through the termination of the trust, of which it has paid 14.1% of projected distributions through 12/31/2012. The projected distributions were based on a $4.10 / MMBtu natural gas price, with a portion of the early year production hedged. The target distribution level assumes that natural gas prices rise to $9 / MMBtu cap starting in 2027.
Risk to Investors
Trusts are unique financial investments; an investor must look at the specific characteristics in order to assess whether the market price paid for the assets will provide a fair return if held to maturity. In the case of ECT, there are significant warning signs that the present price level is significantly in excess of what a prudent investor should expect for taking on the risk of this type of investment.
- High early life trust asset depletion at low gas prices: The trust has already consumed almost 25% of its proven assets in 3 years, at a time when gas prices have been very low. Currently, the run rate of target distributions relative to reserves consumed is at 61%, a significant under-performance to the initial valuation of $20 per share.
- Large price increase assumed in target distributions: The natural gas price assumed in the target distribution forecast in the IPO prospectus assumed a rise to $9 / MMBtu cap starting in 2027. This is a wild card in a market where natural gas is considered plentiful for many years to come in continental North America. A sounder assumption for the average price in a supply unconstrained market should track closer to inflation in general.
- High premium paid relative to current PV-10: The PV-10 on the current reserves is $78.5M, while the trust market capitalization is $322M or fully 4 times the current PV-10 of the trust.
Fair Value Estimate of ECT Unit Share Price
ECT investors based on the structure of the trust receive an implied rate of return based on the sum of the distributions they will receive up to the trust termination date.
In order to assess what a fair value for the trust is, an investor must have a rate of return expectation they are willing to accept for the natural gas reserves held by the trust. For me, energy-related assets, given the level of volatility in the returns, deserve a 10% rate of return. Some may argue it should be lower today, but it is up to an investor to set their risk-reward tolerance rate.
The second critical element in calculating the fair market value of the trust is making an assessment of the cash distribution stream that the unit holder can expect to receive going forward. I have taken the target distribution levels as published in the trust IPO prospectus for the time period March 31, 2013 through the termination date for the trust and discounted the target distributions under several scenarios:
The first scenario assumes the current performance rate in terms of the level of quarterly trust distributions relative to target continues through termination of the trust. Under this scenario, the fair value of the trust that provides the investor a 10% return is $11.95.
In scenario 2, the fair value is calculated assuming the trust is able to fully realize its target distribution level on schedule beginning in March 2013. Under this scenario, the share price providing a 10% return is $19.30.
Given the data, scenario 1 seems to be much closer to what future results are likely to be. In scenario 2, a lot has to go right, beginning with a distribution level of $.945 announced for the upcoming quarter.
I have also done a calculation of the implied rate of return assuming current performance of the trust. This shows a valuation of $18.35 at a 2% rate of return. Investors would be better off buying a 20-year U.S. Treasury bond.
In other words, buyers beware when purchasing ECT as an investment.