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 SandRidge Mississippian Trust II (SDR) based on material information released by the Trust in the annual 10-K published on 3/15/2013. The information contained confirms analysis in the original article expecting revisions, and provides clearer detail of the impact of decline in well performance and reserve mix on the current Trust value, as well as the positive news that probable reserves held by the Trust are being successfully converted to proven reserves - mitigating the decline in Trust value longer term.
SandRidge Mississippian Trust II PV-10 update on 12/31/2012
The table below provides a comprehensive summary of the PV-10 of the SandRidge Mississippian Trust II published in the Trust 10-K on 3/15/2013. The present value of proved reserves held by the Trust showed a decline during the year, with the current PV-10 calculated at $9.80 per unit. The report below looks at the changes in the PV-10 from the IPO point of the Trust until December 31, 2012, about 8 months of performance. During this time period, the PV-10 has decreased by (27.4%).
During the period from April 23, 2012, the date of the Royalty Interests conveyance, to December 31, 2012, the Trust recognized reductions to reserves associated with proved properties of approximately 5,618.5 MBOE as a result of negative revisions due to pricing and well performance as additional information was obtained through the continued horizontal development of and production from the Mississippian formation.
Additionally, approximately 6,484 MBOE were converted from probable reserves to proved reserves. At IPO, the probable reserves were valued at $211M in the proved plus probable PV-10 at IPO. The total initial conveyed value at IPO of proved plus probable was $882M. Proven reserves only, as shown in the table above, were conveyed at a value of $671M. The additional reserves in the probable estimate were 8940 MBOE. Fears in the market about the Mississippian play development appear to have heavily discounted the value of these reserves. Based on the initial estimate, there remains additional reserve upside potential of 2456 MBOE between now and when drilling is completed.
Proven Reserve Summary
From a proven reserve standpoint, when revisions for previous estimates are netted against the extensions, SDR showed an improvement of 865 MBOE. The proven reserves added to the Trust from the conversion of probable reserves have mitigated the drain on Trust value observed from the decline in well performance.
Reserve Impairment Due to Production Mix
The reserve report also shows a major shift in production mix going forward. In the future, SDT will be much more levered to the natural gas price curve. The table below summarizes the shift in reserve mix:
The new mix is 28% oil, 15% NGL and 57% Gas. The projected mix at IPO was 46% Oil / 54% Gas. Given the price differential in the market between natural gas on an equivalent basis to a barrel of oil, the reduction in long-term stable oil reserves is detrimental. The table above summarizes how the shift in mix has reduced the current price level realized by the Trust has been reduced by 30%, with approximately 17% of the decline being attributed to the shift in mix, the remainder weak natural gas prices. A stronger natural gas pricing market will benefit the Trust, but a permanent value gap of about 15% is likely to remain.
Drilling Progress - What is the Risk of Further Impairments?
Since IPO on April 23, 2012, SandRidge drilled 83 Trust Development Wells, and had 99 remaining wells to be completed.
The knowledge that SandRidge has gained about the Mississippian Play is reaching a point that the risk in reserve adjustments going forward is lessening. Usually management tries to get all the bad news out at once. The primary remaining risk is how new wells brought on-line will perform. In terms of drilling, the amount of proved, but undeveloped reserves at SDR is now 40%. So the drilling risk remains significant. The total number of wells remaining to be drilled is 99 (48% of wells obligated to be drill by SandRidge), and these wells are on schedule to be completed in the 2013 and 2014 timeframe.
Assessment of Value - Shares Valued at Relative Bargain at Current Price
SDR's PV-10 value per unit is $9.50, which is 24% below the unit price close of $12.50 on 3/15/2013. While the share price is a significant premium to the PV-10, since the Trust is now more levered to natural gas prices, the premium is partially explained by the $2.24 realized average price of natural gas used in the calculation. A PV-10 adjusted of $11 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, however, the SDR market price relative to its PV-10 is an outlier. SDR is trading at a 1.32x PV-10. Its peer group is trading as follows: (SDT) - 1.75x, (CHKR) - 1.80x, (ECT) - 3.42x. Only in relation to (PER) that has a 1.14x ratio does the relative ratio begin to make sense economically. (Note: The SandRidge Permian Trust is more heavily weighted in oil reserves than all of the other reserves in the peer group.)
The ratio directly to SDR's sister Trust SDT is a gap that needs market resolution. Purely on a MBOE commodity basis, SDR is actually more valuable than SDT, but is trading at $12.50 versus SDT's price of $14.48. The underlying properties of each Trust are very similar. The only difference at this time is that SDT is more mature and therefore has less drilling risk remaining. However, the information about the properties is now more mature, so I expect that the fear about SDR should lessen within the next 6-12 months and the value differential between these two Trusts will close.
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, buying SDR for $11 per unit would be a relative bargain. This price level implies a 10% rate of return to the termination of the Trust. However, the Trust is not trading in this price in the market.
The question is should you pay a premium above $11 for SDR, 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 steam 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 -15.80%.
At the current $12.51 price of the Trust, and adjusting the future stream of Trust target distributions on average by (15.8%) starting with the next distribution through Trust termination, the implied rate of return of a Trust unit held to Termination is 15.8%.
In my opinion, until a better track record is established over the next several quarters, buyers of SDR should continue to demand a 15% return on a lower expected stream of distributions than projected at IPO for entering the investment. Adjusting for these changes, the current unit traded price is slightly undervalued, so it continues to be a risk-reward bargain.