Seeking Alpha
Event-driven, deep value
Profile| Send Message|
( followers)  

This article is a follow up to Part I, a bullish article I wrote on Chesapeake Granite Wash Trust (NYSE:CHKR). It is an oil and gas royalty trust that began in 2011 and terminates in 2031. The thrust of my first article was that the widely followed "PV-10" number, which is published by all such trusts due to SEC mandate, should not be confused with fair value in calculating your buy price for the shares (technically called "units"). Such confusion has, I believe, recently punished CHKR's share (unit) price down to what I view as a very undervalued sub-$15 range. The market price has essentially chased CHKR's fallen PV-10, which dropped due to 1) a 2012 downward revision of estimated recoverable reserves, and 2) a new methodology of simply projecting low 2012 natural gas and NGL prices until the 2031 termination (with no inflation adjustment). This article offers a detailed analysis of the value of CHKR shares using my own conservative valuation approach, which is completely independent of any PV-10 methodologies.

Discounting Can Obscure

As I pointed out in my first article, any calculation of 'present value of future estimated cash flows' can vary greatly depending on the discount rate that is used. For this reason an investor using a 7% rate based on his particular perceived risk/reward profile will arrive at a value far different from the valuation of an investor whose perceived profile calls for, say, a 12% rate. (The SEC mandates a conservative 10% rate for trust reports, thus the name "PV-10.") Because the discount rate used is so subjective and the future cash flows can vary tremendously based on the wells' production and future prices of oil and gas, I find this simple 'discounting of conservative estimates of cash flows' to be flawed in principle for hydrocarbon trusts. Estimates of future cash flows and opinions on a sensible discount rate can vary tremendously, so any PV-10 calculation looks misleadingly precise.

I would actually argue that PV-10 calculations for these trusts necessarily produce 'garbage-in-garbage-out' type numbers. One evidence of this is that today, a mere 3 months from CHKR's 2012 PV-10 estimate of $9.47/share, published in its annual report, another estimate an incredible 42% higher at $13.45/share has appeared here (near the bottom, called "Fair Market Value"). The difference between these two calculations is using 2011 IPO oil and gas price projections for the life of the trust versus using 2012 average prices. Still, both calculations discount all future cash flow estimates at the 10% annual rate, which I find to be much too high for today's historic-low interest rate environment, as I argued in my first article. Thus PV-10 produces an excessively conservative valuation. PV-10 also completely ignores upside potential, which in fact can be tremendous in these energy plays.

Needed: A New Method for Valuing Oil and Gas Trust Shares

I use a scenario analysis that is in a sense simpler to implement than PV-10 since it avoids discounting cash flows using an arbitrary discount rate. I will forecast cash flows conservatively and then instead apply a "payback" or cost basis reduction type of analysis. Then I'll assume some additional value accrues to the shares since unitholders would capture excess returns if oil or gas prices were to rise in the future. This estimated payback analysis will seem a crude method to some who will object that it largely ignores the time value of money, but I justify it thus: future royalty payments could fall into a such a very wide range depending on unknowable future hydrocarbon prices and productivity levels of these wells, that there is necessarily a gambling element to owning oil and gas trusts. They are not investments where simply discounting future cash flows makes sense for one simple reason: these trusts' future cash flow ranges cannot even be estimated confidently, let alone the cash flows more narrowly. This is especially true in the later years of the trust. Risk is fairly high but reward potential is actually much higher (provided the shares were purchased as cheap as they have been recently).

The reward potential outweighing the risk is because the yield risk during the early years is surprisingly low -- the early years' extraordinarily high yields are virtually assured, as we shall see. The early years' extremely high distributions I therefore view basically as reductions in my cost basis. It is the later years' distributions where both risk and reward lurk; these distributions could vary over a huge range depending on future oil and gas prices and how productive the wells prove to be. Eventually of course all wells' productivity falls off sharply but nobody knows when for a given well or field. This is especially true for these horizontal wells since horizontal drilling is a fairly new phenomenon. However, the 10-K saying that "the production from one horizontal well is typically equal to the production from several vertical wells" is encouraging.

Background for My Valuation Analysis

Let us dig into the nitty gritty of handicapping the probabilities of future cash flow ranges to CHKR unitholders. Currently 127 wells are drilled, all of which are producing. The parent, Chesapeake Energy (NYSE:CHK), is drilling an additional 60 wells for the trust with an estimated completion date of June 2015. Roughly two or three new wells are now being completed in a typical month.

FY 2012 began with 77.5 producing wells and ended with 124 wells. Using a simple average over the course of the year of 100.75 wells, we see from the 10-K that these 101 wells generated $116.5 million of "distributable income" in 2012, which was paid out to unitholders. This amounted to $2.49 per share ($2.63 was actually paid out due to the parent-owned subordinated shares suffering reductions for not meeting all quarterly thresholds). Several facts are highly encouraging in light of this high 2012 distribution level, namely:

  • A solid $2.49/unit royalty was generated and paid from the production of only 100.75 wells (average) out of the 187 total that will be drilled by 2016 on behalf of unit holders. The addition of 86.25 more wells by 2016 is thus bullish for supporting substantial distributions (at least in the earlier years) even if oil & gas prices were to fall and some wells' productivity were to taper off sharply. Think of it as 86 additional (85% more) wells coming on line that will be generating additional income which, at minimum, will provide some cushion against the unknown.
  • The solid $2.49/unit was generated despite historically low natural gas and NGL prices during the period (though partial hedging likely provided significant benefit to the 2012 income); these prices have already risen approximately one third from the 2012 averages while fallen gas inventories and other factors are currently supporting prices for the foreseeable future.
  • Even though 25% of the outstanding units are held by the parent in "subordinated" status until one year after all the wells are drilled, this buffer of the subordinated units being last in line for any distributions was not even needed in 2012. The 100.75 wells' production (even at low 2012 gas prices) would have supported $2.49/unit, even without subordination, while $2.50/unit was "safe" due to the subordinated units absorbing any and all shortfalls before the publicly owned units received a penny less than $2.50. This speaks to a very high level of protection for the minimum distribution thresholds through June 2016. In June of 2016 the subordinated units can convert to common units so protection then ends. Per the 10-k, the total of the 14 remaining distributions through June 2016 at this highly likely subordination threshold minimum totals $9.02 per share.
  • All the completed wells in the trust are still producing despite some of them apparently having been drilled perhaps as early as 2007 (2011 10-K, page 3).
  • These wells' still producing, enough to support $2.49/share in 2012, during such a low natural gas price environment, supports the 10-K's statement that these fields "were generally deposited as deep-water turbidites that result in relatively low risk, laterally extensive reservoirs" (emphasis mine); I think this likely bodes well for production being substantive for some years to come rather than falling off a cliff soon as a few skeptics say, the 2012 downward revision of reserves notwithstanding.

Pricing the First Piece

I will now perform my estimate of CHKR shares' fair value in two pieces. The first piece is valuing the distributions during the period from now until June 2016, at which time the 25% of shares that are currently subordinated convert to regular common units. This subordination means that these 25% of the units receive nothing each quarter until the other 75% of units receive the quarterly threshold minimums -- around $.69/share through 2015. This results in low risk minimum distributions from now through mid 2016 because the wells are not yet too depleted during this period. In addition, even during 2012's low natural gas price environment, and with an average of only 100.75 wells pumping, the trust generated sufficient income to meet 2012's minimum $2.50 distribution thresholds -- minimums which from 2013-2016 average a bit higher at $2.68, but with far more wells producing. All this makes the minimum distributions through June 2016 nearly assured (unless hydrocarbon prices fall hard and stay down through 2016).

So here are the probabilities I would assign to the following total distribution ranges, combining together the 14 quarterly distributions to be paid for Jan. 1, 2013, through June 30, 2016:

  • Below $8.00 -- very slim chance; the subordination threshold quarterly minimums total $9.02. These minimums are only 7%-11% higher than the 2012 minimums, despite the much higher well count, while natural gas and NGL prices have risen sharply from 2012 levels. Thus the $9.02 is quite safe in my view.
  • Between $8.00 and $9.02 -- 10%-15% chance; I believe the minimum thresholds each quarter, which total $9.02, are safe for several reasons I've addressed above. However, I always acknowledge that my analysis can underestimate some piece of the puzzle, so I will allow a chance that even the 25% subordinated units' buffer and the additional wells coming on line could be insufficient to support the minimum distributions completely. Another possible but unlikely downer would be a large fall in hydrocarbon prices that persists through 2016. The trust sells mostly natural gas and NGL by volume but its profits are overweighted to oil, so the trust is quite sensitive to a sustained fall in crude oil prices. I believe sustained low prices is by far the largest risk in these earlier years.
  • A minimum of $9.02 -- 85%-90% chance; for reasons given above, this $9.02 subordination threshold minimum seems quite safe. If it is not met, chances are that it won't miss by much.
  • ~$10.00 range -- 45% chance; I think the new wells coming online each month and other positive factors addressed above, combined with the possibility of rising natural gas or oil prices could mean that distributions above the minimums are not at all unlikely. Exceeding the minimums by an average of $.07 per quarter over the 14 quarters would put the total distributions at $10.00 between now and mid 2016.
  • ~$11.00 range -- 25% chance; with good production and/or significantly higher natural gas or oil prices ... not terribly unlikely. When commodity prices boom it can go right to the bottom line for producers. (Costs do not increase in proportion with revenues.)
  • ~$12.00+ range -- 15% chance; both good production and much higher prices could push distributions up to near $1.00 per quarter. This is not far-fetched. Strong housing starts, falling unemployment, rising home prices, recovered household wealth and other indicators suggest economic recovery may be on the horizon and spread globally, despite the current eurozone troubles. A genuine return to growth rather than the anemic jobless recovery of recent years could mean strong demand (and thus prices) for hydrocarbons. Remember 2007 when energy prices soared? That was the last time that economic growth had a tailwind globally.

Per the above analysis, a recent buyer of CHKR at $15 can reasonably expect to recover at least $9.02 in dividends by mid-2016. That would leave a remaining cost basis of $5.98/share to own any revenues generated by approximately 187 wells for the following 15 years. Yes, I said "revenues" not "profits" since the trust's overhead is very minimal. Only a small deduction is made for administrative expenses for the trust, which has no employees. Drilling and marketing services costs are borne by the parent, not the trust.

To the PV-10 faithful who would say I must discount the $9.02 to a present value, my response is why? The $9.02 I view as a minimum -- no discount is needed because the potential is there for $10-$12-plus. Nobody knows what the number will ultimately be. But the potential for $11 or $12 should surely be worth something. To discount the $9.02 down to $8.50 of present value is to ignore that upside potential. To discount the $9.02 at the very high annual rate of 10% would just distort things further. I see my cost basis method resulting in $5.98-maximum-basis-in-2016 and then looking forward 15 more years as a far more sensible approach. The $9.02 is a nearly assured minimum reduction in cost basis -- any extra reduction would be gravy that I don't factor into valuation to be on the conservative side.

The real question then is whether $5.98 (maximum) is an attractive price to pay for the second piece -- the final 15 years of more volatile, riskier quarterly distributions from mid 2016 to mid-2031, plus the termination value. I think the answer is a resounding yes.

Pricing the Second Piece -- Plus the Implicit Call Options

I will answer the above question, again, not by simply a PV-10-like calculation based on very conservative low-end cash flow estimates (using historically low prices discounted at a high annual rate). Rather, we do have an objective pricing model available to us: the options markets. For the "$5.98 or less basis" that I am paying to own a piece of these wells' last 15 years of production, I can break the valuation of this second piece down into 1) a conservative low-end cash flows estimate, plus 2) something extra for in effect owning call options on oil and gas prices over the final 15 years. In essence that is what is owned: a stream of some reduced amount of distributions from the ever-depleting wells for the final 15 years, plus call options on oil and gas prices since the distributions would rise sharply along with oil and gas prices. How many call options? Hard to say. While the amount of hydrocarbons to be produced in the following 15 years is unknown, it is sure to be something. Each quarter for 15 years some royalty check can reasonably be expected, but the amount could vary greatly. Here is what we do know:

  • The earlier years from 2016 to circa 2020 are likely to have very significant distributions, albeit much lower than pre-June 2016.
  • Beyond 2020, all wells will be at least five years old so well depletion should become an increasingly negative factor over time.
  • Beyond 2020 there will likely still be some dividend each quarter as some oil and gas will be produced, but I will be extra conservative as to the MBOE quantities produced. If the wells produce more -- as they very well might -- then that would be pure windfall not even factored into my valuation.
  • Prices for oil and gas beyond 2020 are anybody's guess. Events like clean energy technology breakthroughs or carbon tax legislation or large hydrocarbon discoveries could depress prices. However, the fact that global energy needs are sure to be greater than today and that oil and gas are a depleting and nonrenewing resource tilt the scales in my view toward higher prices rather than lower. I'm willing to risk a small piece of my $5.98 to bet on that. (None of my other $9.02 will be at risk since I will have gotten at least that much back in dividends.)

So by June of 2016 a recent buyer of CHKR at $15 can expect to have a maximum remaining basis of $5.98. With luck it could be as low as the $4-$5 range due to prior distributions being above the minimum thresholds. At that point most of the 187 wells will continue to produce hydrocarbons, but over the ensuing 15 years the productive well count will likely fall substantially. The total amount of hydrocarbons being produced is almost certain to fall drastically compared to the early years.

Here's my conservative valuation for the second piece -- the cash flows beyond 2016 -- for which a $15 buyer today will have paid a maximum of $5.98 net:

  • The trust's 10-k target distributions are only estimated through mid 2017. Those figures average $.50 for each of the 4 quarters from mid 2016 to mid 2017, or $2.00 for the year. Haircutting these trust estimates by 50% to be conservative I will estimate a $1.00/unit distribution for that year. I will then assume, from this conservative starting point, an 18% drop in production (at constant prices) each year until termination. This would produce the following annual dividend estimates for the final 15 years: $1.00, $.82, $.67, $.55, $.45, $.37, $.30, $.25, $.20, $.17, $.14, $.11, $.09, $.07, $.06. These sum to $5.25 in distributions for the final 15 years, for which we may have paid as much as $5.98 today. (I very conservatively assume the 2031 terminal dividend from the sale of the Perpetual Rights is zero -- some think it will be a couple dollars.) Receiving $5.25 for $5.98 sounds like a money-loser ... or is it?
  • Remember that the trust's 2016-2017 distribution estimates use historically low 2012 natural gas and NGL prices, and recall that to be extra conservative regarding later years' well production, I cut that distribution estimate in half. This means that receiving just the $5.25 beyond the initial minimum $9.02 in my view is probably fairly close to a worst case scenario. If that is true, then the worst that happens if buying CHKR recently at $15 is that in the very long haul you basically just get your money back, less inflation. But you do get your money back. Compare that with buying call options on the price of oil & gas stretching for 18 years into the future, in which there is a very strong likelihood of losing most of your money! First, there is no counterparty that will sell you calls on hydrocarbon prices 18 years out, and second, if there were such a counterparty the premiums to buy such options would be insanely high for such a long time horizon. Even on a dwindling production, the market value today of the 18 years (72 quarters) worth of call options alone might be on the order of $25-$50/share. CHKR unit holders basically get all those calls for nothing since eventual distributions of at least $9.02 + $5.25 are virtually assured in my estimation. Another piece is "What if horizontal well production does not decline as rapidly as expected?" You effectively own call options on the production volume too. These are the reasons why I said CHKR at $14 was a "screaming buy" in my first article. While the worst case scenario is zero return on investment (but at least a return of investment), the best case scenario is soaring distributions (and share price). The soaring is because the royalty income is in effect leveraged to oil & gas prices and well productivity, at something greater than a 1:1 ratio. Moreover, buying the shares so cheap effectively amplifies this "earnings leverage," while also tremendously reducing the risk that is normally inherent in a leveraged play. The result: The worst case is not that bad while the best case is enormous yields on share cost that last for many years.
  • Remember that since we are projecting cash flows based on especially low 2012 natural gas prices, the call options start paying off with even fairly small price increases. In other words, our calls have strike prices that are at the money based on low 2012 natural gas prices. That makes them very valuable indeed.

Conclusion

In sum, oil & gas trusts are not conservative investments since the later-year dividends are highly unpredictable and the shares' value at the termination date may only be a pittance. In my view simply taking the present value of conservative, low end estimates of CHKR's future cash flows, heavily discounted for risk and the time value of money, does not make sense as it completely ignores the high end possibilities -- chiefly that oil and gas prices might rise substantially during the coming 18 years.

In effect, owners of oil and gas trusts own some conservative base level of future royalties plus a medley of call options on oil and gas prices stretching out for the life of the trust. In an options or futures market, such instruments with strikes that are at the money and expiring as far as 18 years in the future would carry extremely high premiums. For some reason, option-equivalent rights embedded within trusts are dirt cheap now. Buyers of CHKR and certain other trusts at the very depressed share prices of late are in effect getting potentially valuable long term call options for free. These 'calls' might end up expiring worthless, but on the other hand they might pay off big.

It may not even be necessary to wait long to profit big. Hydrocarbon prices rising as little as 10%-25% from current levels could easily result in oil and gas trusts' highly volatile share prices rebounding sharply. (Buyers of CHKR shares near the lows of the last two weeks have already enjoyed double digit gains as I write this -- now that's volatility!) And even if the shares don't rise, every huge quarterly dividend through 2016 is risk-off money that can be redeployed elsewhere.

Source: Chesapeake Granite Wash Trust Is A Strong Buy, Part II