Units of Chesapeake Granite Wash Trust (NYSE:CHKR) recently plunged following the release of its 2012 annual report (10-k). They've fallen to as low as $13.07 (from a prior 52-week range of $16.58-$27.00). It was actually not until the 10-k was digested for five days and a bearish SA article appeared on March 20th that the shares began their nosedive. I have personally bought shares heartily after this big plunge and this article explains why.
The crux of the bearish article was that the present value calculation (PV-10) of the estimated future royalty payments per unit was far below the market price of $17.31 at the time. In other words, by this PV calculation, the shares were supposedly way overpriced.
In addition to the trust's weak 2012 realized gas and NGL prices, the 10-k reported that the original (2011) 44,000 MBOE estimate of Proved reserves fell to 28,000 MBOE due to 6,000 of production and 10,000 of negative estimate revisions, net of new discoveries. Sometimes there is good luck drilling and other times bad. The problem was primarily lower pressures than expected in some wells. It is notable though that of the 127 wells drilled so far, zero are dry wells. Sixty wells remain to be drilled in the next few years for a trust total of 187.
The article's author calculates a current fair value of $11.42 per unit for an investor demanding a 15% internal rate of return, or $13.45 per unit at 10%. This $13.45 is actually up a whopping 42% from the $9.47 PV-10 that the trust calculates in its 2012 annual report. The huge 42% rise in value in just 3 months is due to the price of natural gas having risen to currently ~$4 from the $2.76 average price used for 2012, as well as LNG prices having also risen by approximately a third. (Crude oil has been roughly flat.)
Does it seem crazy that an estimate of the fair value of a royalty trust that will produce oil and gas for the next 18 years would shoot up 42% in just 3 months due entirely to volatile energy prices? Well it is crazy -- so don't take volatile PV-10 too seriously as any measure of fair value. When the market does, it can create a great opportunity as is happening now.
PV-10 Does Not Mean 'What It's Worth'
The problem, or rather the opportunity to buy now as I see it, is that PV-10 is often used by trust investors as a proxy for fair value, which it is not. PV-10 is actually a measure for oil and gas trusts mandated by the SEC that is designed to be very conservative (due to the high mandated 10% annual discount rate of all future cash flows). It thus understates value, especially in a very low interest rate environment like today when this 10% internal return assumption is not reasonable. The PV-10's understatement of fair value grows increasingly large the lower the interest rate environment and the further in the future the cash flows may be.
For example, a distribution 10 years hence would be worth 59% more today if using a 5% discount rate versus 10%. A cash flow 15 years hence is worth a whopping 101% more today if using a 5% discount rate versus 10%. So the rate that is used makes a huge difference in discounting all of a royalty trusts estimated future cash flows to the present. Add to this that oil and gas prices could be far higher in the future and it's clear that a PV-10 based on current prices doesn't mean anything. In fact we just saw the PV-10 for CHKR move up 42% in a mere 3 months! (That's with no change in Reserve estimates.)
While a 10% discount rate may have made sense back in the early 1980's when you actually had the alternative of putting your money in a risk free Treasury bond that yielded 10%, today your low risk parking places for cash yield a pittance. So even in relatively high risk royalty trusts I think that today using a discount rate as low as 5% could make sense for many investors. This is for two reasons: First, there is no need for any inflation-risk premium. Oil & gas royalties are not fixed income like bonds -- because oil and gas realized prices are not fixed but rise along with inflation you're covered automatically. Second, there is upside. Unlike a bond, royalty trusts can experience windfalls and the potential for upside should be worth something. In effect, upside potential should reduce one's discount rate compared to an investment that has no potential for positive surprise. For some reason trust investors tend to obsess about the risks of production disappointments and low realized prices much more than giving any credit to the fact that production can beat estimates or that realized prices can soar. This is ironic when you consider that the very existence of CHKR is itself a huge positive surprise that was made possible only by the development of fracking and horizontal drilling techniques that did not exist a decade ago. These properties were not believed to have value just a short time ago -- big surprise.
By the same token, when the trust dissolves in 2031 (and its interests are sold on behalf of unitholders) maybe new techniques or discoveries will render these properties still more productive than anyone can currently imagine. I conservatively assume a 2031 terminal value of zero for CHKR in my calculations, but I just might be pleasantly surprised.
It's also noteworthy that the trust previously projected in its distributions, and the SEC permitted, an assumption that gas and oil prices beyond 2014 would rise annually by 2.5%, to reach caps of $120/bbl for oil in 2025 and $7.00/mmbtu for gas in 2028. So the latest 10-k's PV-10 which projects low 2012 prices forever is not even an apples to apples comparison with their own prior estimates. That alone surely accounts for a significant chunk of the drop in PV-10 from the prior estimates. Do you want to judge CHKR as an investment by projecting low 2012 natural gas prices 18 years into the future without even an adjustment for inflation? I doubt it.
The Cynical View of Oil & Gas Trusts
Skepticism is wise in investing. I make a point of investigating these 3 factors before buying any equity: the alignment or not of management's interests with shareholders, executive compensation levels, and any insider trading in the shares. I also try to gauge whether the SEC filings, news releases and conference calls seem vague and evasive or specific and forthright.
Now that CHKR's Proved reserve estimates have come down 22.86% since the IPO (notwithstanding production that has occurred), skeptics have come out crying foul. Cynicism historically has been probably nowhere more justified than in oil, gas and mining equities. Many years ago, before regulation by the SEC, many stock market scams involved fabricated geoengineering reports that exaggerated mineral wealth in order to fleece investors. There's no way for an investor to know what is in the ground so the potential is always there to inflate estimates.
One skeptical view of oil and gas royalty trust spinoffs in general is the question of "Why would an E & P parent sell off the future production of given properties if that production were so valuable?" It's a valid point, but it's not a worry in the case of CHKR. I've studied the trust's structure and as a CHKR unitholder myself, I like how the trust has aligned the parent's with CHKR unitholders' interests.
In fact, the parent and driller/operator of the wells, Chesapeake Energy (NYSE:CHK), is the majority common unitholder of CHKR. It owns 23,750,000 of the 46,750,000 or 50.8% of the outstanding units of CHKR (of which 11,687,500 are subordinated until the 4th quarter after its drilling obligation is completed). CHK's common units of CHKR are not special in conveying any rights that other unitholders do not have. I have also studied the trust documents and find that the subordination and incentive payout thresholds and development well drilling schedule terms do create incentives that align CHK's interests with CHKR unitholders. And at least until 1 year after the drilling is complete, any and all revenue disappointments will likely be entirely absorbed by the subordinated units owned by CHK. Finally, if there had been collusion to inflate reserve figures initially only to reduce them later, as they were reduced in 2012, it would not have been in CHK's interest to write down the reserves until after it had an opportunity to sell some of its 50.8% stake. That sizable stake ensures that CHK will want to do right for CHKR as both driller and operator.
I intend to follow up this article with a Part II that offers my detailed valuation analysis for units of CHKR. I find the shares currently trading at ~$14 to be a screaming buy based on my own scenario analysis over the potential ranges in which total future distributions might fall.