This article provides a relative performance and valuation analysis of five U.S. Royalty Trusts in the energy sector that were launched since early 2011. Included are Chesapeake Granite Wash Trust (CHKR), SandRidge Mississippian Trust I (SDT), SandRidge Mississippian Trust II (SDR), SandRidge Permian Trust (PER), and Whiting USA Trust II (WHZ).
Recent Stock Performance
The U.S. Oil & Gas Royalty Trust sector has taken a beating over the past year beginning in the first quarter of 2012. Across the group of Trusts in this review, the worst 12 month performer in stock price performance is SDT, down 61%, with the remainder down from -27% to -42%. In general the SandRidge Trusts in the Mississippian Play are the worst performers.
During this time period energy prices have been relatively stable. Only recently have oil prices begun to show some weakness and may explain a part of the recent trading declines. But the volatility in this sector is very high. All of the Trusts currently have hedge contracts in place for the majority of their production through 2014 and 2015. Fundamentals currently are only a small part of the systematic share price decline across all of the Trusts.
What appears to have stoked the "catch a falling knife" market decline is a misalignment of what the Trusts are capable of delivering, and where the initial expectations were set at IPO. This led to a mispricing of risk by initial investors. There is also evidence that income investors post IPO searching for yield bid up these shares to unrealistic levels.
These Trusts cannot be evaluated on their current dividend yield. The true value of the trust has to be estimated based on its intrinsic value and the expected level of distributions, which will be made between today and the end of the life of each Trust.
After several years of production and distribution data, the potential of each of the trusts is now becoming clearer.
Factors Affecting the Value of Each Trust
There are several major variables that must be considered when assessing the relative value of a Royalty Trust:
- The remaining undepleted reserves per unit at the time of purchase, and the anticipated quality of the reserves
- The production level of the Trust relative to the plan for bringing new production wells online, and quality of new wells brought online
- Oil and gas prices received by the Trust, including impact of hedges in place
- The quality of unit distributions
Overview of Each Trust
The table below provides a snapshot of the structure of each trust in this analysis:
(SDR is the SandRidge Mississippian II Trust excluding all probable reserves; SDR** includes proven and probable)
Each Trust is young, under two years old. With the exception of WHZ, all have 18-19 years to the Trust end of life. All are finite in term with a fixed termination date in which the unit-holders will receive a final payment based on the sale of remaining trust assets. The unique aspect of a U.S. Royalty Trust is that it is an investment that will not rise in value over time. The underlying value of the Trusts will decline as the reserves held by the Trust are pumped and sold. The "depletion" is embedded in the distribution level paid each quarter to unit-holders. You can estimate the current remaining reserves held by each trust by reviewing the "% of Reserves Depleted" for each Trust.
Production Performance of Each Trust -- How Well Is the Drilling Going?
Each Trust is currently increasing production during the first several years of life based on a plan to add a certain number of new drilled wells ("PUD Wells"). These new production wells are riskier than ones already in production because it is not absolutely known what production level will be achieved until a well is brought on-line. It is important to evaluate Trust performance in order to assess the quality of current production. I have looked at the production levels of each Trust using a Trailing 12 month production rate and compared the production rate per month compared to the rate expected at IPO:
The above table shows that CHKR, PER and SDT are increasing production rates as expected. SDR is only 9 months old and just beginning to ramp up drilling. SDT has shown the most significant gains from the baseline production rate (33%), reflecting a very aggressive drilling plan. Current public data on the SandRidge Mississippian Trust I showed remaining undeveloped reserves of only 36% at the beginning of 2012, and this number was likely reduced significantly over the past year. By comparison, the SandRidge Permian Trust did not grow production as quickly (11.4%). As of the end of 2012 (see company 10-K), the Permian Trust had 43% of the proven reserves undeveloped. Likewise, the CHKR Trust is showing a slower roll in developing the reserves in the Trust, with 58% of the reserves undeveloped/non-producing as of the beginning of the year.
The production rate data requires some interpretation of available public data to assess the quality of production at each property. This review provides the following insights concerning the SandRidge Trusts:
- SandRidge Trust in the Mississippian play are beginning to show different characteristics from the initial IPO projection. The new wells are showing higher gas content (approximately 2%) and a production curve which is more spread out over time, i.e., lower in upfront production. This may explain why the drilling activity has been sped up -- more wells are being put into production early in order to meet the distribution targets.
- The analysis of the drilling data on SDT is expected to apply to SDR, which is the younger Trust in the Mississippian Play. The properties, which comprise SDR are considered to be tougher to drill, and the fear is that they will not pan out as advertised. It appears there is a severe discount being placed on the IPO reserve PV-10, primarily focused on the probable reserves in the Trust. When SDT and SDR publish their 10-Ks this Spring, (expected end of March 2013), a better understanding of the impact on the PV-10 will be possible.
- SandRidge Permian Trust appears to be affected by the market sentiment with the Mississippian play Trusts. However, the Permian properties do not show major issues in the public data. In fact, the proven reserves since IPO have been adjusted upwards. The 10-K just published by PER reflects the most up to date information about proven reserves, and the proven available MBOE is above the IPO estimate even after two years of production.
The remaining two Trusts in the analysis (CHKR and WHZ) do not currently have any publicly stated issues concerning production, and the data do not show reason for concern at this time.
Oil and Gas Price Changes Impact on Each Trust
During the past year energy price levels varied in the typical broad range that is characteristic of the energy markets. Oil traded in a range (table shows end of month WTI closing prices) from the mid-$80s to $107. Likewise the natural gas prices were in a wide range from $2 in the second quarter, recovering to trade in the $3.50 range at year-end.
Each Trust is impacted by oil and gas price changes based on the actual time and to whom they sell the bulk of their production. In addition, hedges that a Trust holds can help or hurt the actual realized price of production. In the table, you can see that each Trust had a slightly different price level realized in the third quarter of 2012. The price levels received for oil in general had a positive impact on distribution rates. The drag on performance during the period was natural gas prices -- and the distributions from the Trusts, which are more heavily dependent on natural gas for revenue -- CHKR and SDT, and to a lesser extent SDR -- all have shown lower distributions than expected. The variability in both the oil and gas prices realized for all of the Trusts are a function of market forces and the hedge contracts the Trust holds.
Hedge Contracts Held by Trust
All of the Trusts hedge a substantial portion of their oil production. These hedges extend to the end of 2014 and into 2015, depending on the Trust. By contrast, only SDT has directly hedged Natural Gas production prices. This hedge has helped SDT to keep its realized gas price up in the face of generally low natural gas price levels. The Chesapeake Trust indirectly is hedging its NGL production by using oil derivative contracts.
Putting It All Together -- Relative Share Value Assessment of Each Trust
The best way to assess the U.S. Royalty Trust market is to line a group of Trusts up statistically and compare them on multiple measures. I have put together an analysis based on the current PV-10 and the expected value to be received from the Trust distributions.
Each Trust Based on Relative Adjusted PV-10:
Adjusted for the cumulative reserve depletion since the IPO of each trust, SDR, SDT and WHZ are currently trading below their PV-10 estimated depleted value. Typically the market trades above the PV-10 value, reflecting, among other things an expectation of rising energy prices over time. The PV-10 uses a constant price assumption. The prices currently being used in the PV-10 assumptions are $91 oil and $4 gas. PV-10s for Trust reserves are currently being calculated for annual reporting purposes. In published 10-K's, expect natural gas price levels to go down to $2 for reserve valuation per FASB guidelines. The SandRidge Permian Trust in the above table has already published a new PV-10 using the updated average realized preceding 12 month pricing data for natural gas.
- WHZ: The oil price assumed in the WHZ PV-10 explains a large part of why it is trading at a market discount to the PV-10 today.
- SDR and SDT: SDR is trading at a more significant discount to PV-10 than any of the other trusts. There are likely two good explanations for this discount. The first is that on the SandRidge, Inc. (SD) company 3/1/2013 earnings call it was made public that the production rate of the wells in the Mississippian play (affects both SDR and SDT) is expected to be more "spread out" over time than previously forecast. This has led to analyst revisions in the expected actual proven reserves that the Mississippian Play may be able to produce. Additionally, the reserves from the play are showing a mix which is higher gas (by about 2%) and lower oil. This would lower the overall reserve potential if it is confirmed in the future. Given this information, some discount of the PV-10's of SDR and SDT seems warranted. Based on discount levels to PV-10, shares are trading in a range that gives little if any credit for the probable reserves shown in the SDR prospectus.
- PER: The SandRidge Permian Basin Trust is trading relatively above its PV-10, but was trading at $13.50, virtually at par with an estimate of its depleted PV-10 on 3/5/2013. One possible explanation for the steep decline and recovery is that the Trust is subject to the negative news in the market about the Mississippian production levels. However, it is a completely different property that has been divested by SandRidge so they can completely focus financial resources on the Mississippian play.
Current traded values of all the Trust relative to their PV-10 show they are all relatively conservatively market priced. The market appears to be trading the SandRidge Trusts at a discount to other comparable assets. This evident value gap will be closed in the future by either adjustments in the PV-10 estimate by SandRidge , or by changes in the Trust stock market valuation relative to other traded Trusts as better information becomes known about the Mississippian play.
Examining Each Trust based on Expected Distributions
The true underlying value of each trust is best assessed by estimating the future distributions that a unit-holder will receive from the present until the termination of the trust. In the table below, I have assembled a performance analysis of the recent distributions by each Trust:
In reviewing this data, you can quickly see the effect lower than anticipated natural gas prices are having on distributions, and, that CHKR and SDT are exposed more than the other Trusts. CHKR suffers the most because its natural gas production is un-hedged with the exception of the indirect hedge of its NGL production using crude oil futures contracts. SDT has hedges on approximately 25% of its production through Dec.15 using a $4-$7 collar. The market pricing of natural gas reflects the abundant domestic supply, which will curb pricing power for production for the foreseeable future (possibly until it becomes more exportable). The oil market, which is influenced more by global demand, appears to have more pricing stability.
The distribution analysis also shows the relative strength of PER in meeting unit-holder target distributions. This backs up the view of a relatively stronger underlying oil market from a supply and demand pricing standpoint.
Different from the PV-10, the target distribution levels have assumptions about the price level of oil and gas prices in the future.
In this case, the WHZ trust uses an average oil and gas price. All of the other trusts assume a growth in oil price to $120 and gas to $7 over time (usually the mid 2020s).
Using the expected stream of target distributions as published in the prospectuses of each Trust, a relative value analysis has been performed in the table below. (In the case of WHZ, the stream was imputed based on expected MBOE sales at an 8.4% decline in production per year post 2014).
Examining the "Expected Distributions 10% DCF" line you will see a value which approximates what the fair value of the Trust would be if as an investor you expect a 10% return on your investment, and:
- You agree with the expected market price assumptions for oil and gas implicit in the target distributions
- You agree with the adjustment factor that I have placed on the expected distribution stream in an attempt to estimate the impact of current new market information -- namely the impact of lower natural gas prices and the change in data on the Mississippian Play.
The 10% DCF value is not intended to set a price target. It is calculated to give guidance on the general bounds of what a good price for the Trust is likely to be under the given set of assumptions. It should be combined with the evaluation of the PV-10 to assess the risk/potential rewards inherent in the current traded market price.
Implied Market Rate of Return in Current Trust Stock Prices
The "Implied current share price (IRR)" is perhaps most useful in seeing the pricing differential in the current market bid for each Trust. The SandRidge Trusts are all trading at implied rates of return of 15%, while CHKR and WHZ are valued in the 8%-10% range.
Based on this review:
- All of the SandRidge Trusts are trading at relative deep discounts to their peers. The implied IRR is 14.5% for SDT, 15% for PER and 15.1% for SDR. This reflects significant fear in the trade of these Trusts. On a relative risk basis it appears that PER is most undervalued given it has more long-life proven oil reserves developed and producing. As a total group, the differential in valuation of the three Trusts relative to the total peer group is significant, and although a discount of the Mississippian play is warranted, the group looks oversold.
- The Chesapeake Granite Trust appears to have a middle of the road valuation currently. Trading at an implied 10% discounted cash-flow to expected distributions, at least based on known information, it seems relatively fair valued.
- WHZ is a special case in relative value. The implied IRR for the current share price is 8%. The trust termination date of Dec. 21 is 10 years sooner than the other 4 trusts in the analysis. Given the steady performance of the Trust and the concentration of more stable priced oil reserves and NGL rich natural gas, a lower expected internal rate of return is considered warranted. At an 8% IRR, the trust appears to be fairly valued today.
Portfolio Strategy -- Adding Royalty Trusts to Your Portfolio
There are two articles I have published which review why it is currently important to accumulate hard commodity assets as a hedge against the likely outcome of present Federal Reserve policies. These articles are "Investing in 2013 -- Remember 1977," and "S&P 500 Driving to All-Time High, Buy, Sell or Hold in Your Portfolio."
An oil and gas royalty trust by design is particularly good for investors who need their investments to produce income and also need to protect their portfolio for an extended period of time from commodity inflation. At present, the fear of inflation is low, and the premium to buy inflation protection is equally low. The trusts in this report are trading at and even below their current PV-10, which when you allow for any risks that may be unique to a particular trust, generally means the market is expecting a flat oil and gas price curve well into the future. This is generally a good time to be a buyer.
If you choose to invest in this sector, I recommend strict limits and diversifying your exposure:
- Diversify across Trusts in order to decrease risks unique to a particular oil & gas property.
- Commit no more than .5%-1.5%% of your portfolio to any one Trust. These trusts are similar to high yield bonds on the risk/volatility scale, so manage your exposure accordingly.
- Do not buy these securities for the purpose of trading, and do not expect a capital gain. These are securities that will decline in value through time -- not increase. Each distribution includes a non-taxable depletion amount which reduces your basis in the trust, and you need to budget to redeploy the return of capital portion of the distribution over time into other investments.
If you are an income investor that needs income for the next 18 years, needs a hedge against potential rising inflation, and has the discipline to hold onto the Trust without checking the ticker every day -- a U.S. Royalty Trust can be a good addition to your portfolio at the current market prices.