This article is an update to the U.S. Oil & Gas Royalty Trust - Bargains Available for Disciplined Portfolios article published on 3/12/2013. The information contains a more in-depth review of Chesapeake Granite Wash Trust (NYSE:CHKR) based on material information released by the Trust in the annual 10-K published on 3/15/2013. The new information shows a substantial decrease in proven reserves due to poor actual well results being experienced relative to estimates made in the PV-10 at the Trust IPO.
Chesapeake Granite Wash Trust I PV-10 update on 12/31/2012
The table below provides a comprehensive summary of the PV-10 of the Chesapeake Granite Wash Trust published in the Trust 10-K on 3/15/2013. The present value of proved reserves held by the Trust showed a dramatic decline during 2012, with the current PV-10 calculated at $9.47 per unit. The report below looks at the changes in the PV-10 from the IPO point of the Trust, July 1, 2011, until December 31, 2012, 18 months of performance. During this time period, the PV-10 has shown a substantial decrease of (46%).
The large decline in PV-10 is material and needs to be analyzed closely. Many investors are complacently attributing the PV-10 drops of many heavily weighted natural gas properties across the market to weak natural gas prices during the PV-10 calculation period. But as the table shows, price declines and production cost changes only account for 13.5% of the drop in CHKR's proven reserve value. Volatile declines in natural gas prices have been the norm over recent years, so in looking for value, discounting what is considered a very low level for natural gas prices in 2012 seems reasonable. Assuming prices trend back to $4 gas, the PV-10 would be in the $12 range.
The most significant impact on the PV-10, however, is the revision of quantity estimates, which affected the PV-10 by (20.3%). The majority of the downward revision, which equates to 10,410 MBOE of originally estimated reserves held by the Trust, is non-price related. The non-price related revision is primarily due to current results being below expectation because higher than expected pressure depletion is being experienced in certain areas of the Granite Wash AMI.
Proven Reserve Summary
In relation to the proven reserves held by the Chesapeake Trust, CHKR showed a major downward revision that will be permanent going forward of (10,410) MBOE. The magnitude of the permanent value reduction is estimated at (22%) of the going forward underlying value of the Trust.
The decrease in reserves is due primarily to current results being below expectation because higher than expected pressure depletion is being experienced in certain areas of the Granite Wash AMI.
Reserve Impairment has Small Affect on Production Mix
The reserve report also shows only a small shift in production mix at this time. The table below summarizes the shift in reserve mix:
The new mix is 13% oil, 33% NGL and 55% Gas. The projected mix at IPO was 14% Oil / 33% NGL / 53% Gas. The small shift in mix impacted realized price the Trust received for reserves during the analyzed time period by (3.53%). The remaining price decline is attributable to the decline in Natural gas prices.
Drilling Progress - What is the Risk of Further Impairments?
Based on new drilled wells, Chesapeake has discovered that certain areas of the Chesapeake Granite Wash AMI are delivering lower than expected pressure, causing lower reserve estimates. The primary remaining risk is how new wells brought on-line will perform. It is assumed that the Trust proven reserve estimates now reflect all known bad news. But given the high number of wells that remain to be brought on-line, risk still remains. In terms of drilling, the amount of proved, but undeveloped reserves at CHKR is now 41%. The total number of wells remaining to be drilled is 60 (51% of wells obligated to be drill by Chesapeake).
Assessment of Value - Market Unit Price is Very Expensive on a Relative Basis
CHKR's PV-10 value per unit is $9.57, which is 44% below the unit price close of $17.31 on 3/15/2013. The current traded unit price is a significant premium to CHKR's PV-10 of 1.8x, which should be a concern to investors looking to purchase CHKR trust units. The current premium is only partially explained by the $1.60 realized average TTM realized price of natural gas and $33.22 NGL price used in the calculation. A PV-10 adjusted of $12 seems more reasonable if you believe the fair market value of natural gas is $4, and oil is $90.
On a relative basis to its peer group, CHKR is trading at a high multiple to current PV-10. CHKR is trading at a 1.81x PV-10. Its peer group is trading as follows: (NYSE:SDT) - 1.75x, (NYSE:ECT) - 3.42x, (NYSE:SDR) - 1.32x, (NYSE:PER)- 1.14x.
Estimating Trust Value Based on Expected Future Distributions
If you believe that a going forward price structure for oil is $90.00 and for natural gas is $4.00, then paying $12 for CHKR would likely be considered a bargain in today's interest rate environment. This price level implies a 10% rate of return to the termination of the Trust. However, the Trust is not trading at this market price currently.
The question is should you pay a premium above $12 for CHKR, and if so how much?
The table below has been developed by looking at the expected target distribution stream, which was projected at the Trust IPO. The target distributions assumed a forward price curve of oil rising to $120 and natural gas rising to $7 by 2022. The distributions also were based on a production mix and well performance expectation level that changed substantially in 2012.
To estimate the relative impairment to the expected distribution stream going forward, I have used the PV-10 data to derive a view of the permanent impairment level to the distribution stream. This figure is -22.86%,
At the current price of the Trust of $17.31, and adjusting the future stream of Trust distributions by (22.86%) starting with the next distribution, the implied rate of return of a Trust unit held to Termination is 4.80%. Not a good risk / reward return for an investment of this nature.
In my opinion, the recent AMI revisions introduce major risk that has not been priced into the unit trust current market price. Presently given the risk, buyers in the market should expect a 10%-15% return for entering the investment. Based on this view, the current unit traded market price is considered over-valued.
Additional disclosure: I sold CHKR based on the critical review of the reserve data.