In the late 1990s, as a young stock broker looking to differentiate myself from the herd, I stumbled across my first royalty trust. It was Williams Coal Seam royalty trust. The trust was intriguing to me because it paid double digit income streams based on the price of natural gas that it collected from already drilled coal seam gas wells. Additionally, owners of the trust were eligible to collect tax credits based on production values. That experience was enough to get me hooked. Like so many others, I played the boom in royalty trusts around the turn of the century when the Canadians had pioneered the income trust business model. While the royalty sector is always evolving, there is one thing that I have learned about it. It is far from efficient.
When I read the internet chat boards and talk to potential investors in these vehicles, I have come to realize that they are grossly misunderstood investments. A few trusts exists as legacy assets, expected to produce for decades into the future while most of the new ones have finite lives and are set up as some sort of partnership or OID security. Most are not widely covered by analysts and as such are often bought on the basis of yield alone - which can be a huge mistake lesson but one that is nonetheless frequently learned.
VOC Energy Trust (VOC) is not immune from being misunderstood. In fact, I believe that because it is so misunderstood people get the occasional opportunity to experience outsized profits while the market re-prices. At current levels at or below $13 a unit, I think the inefficient marketplace is about to reward buyers who can hold their nose and part with some money. There is no significant analyst coverage of VOC, though it does sometimes get picked up by data-mining analysts (finance bots) who basically toss the numbers into a computer without knowing anything about the structure of the investment. These pseudo-analysts often use inappropriate equity valuation metrics and bad comparisons to dissimilar companies to make a buy or sell recommendation. This further complicates novice investor misunderstandings.
The Fed's introduction of ultra-low interest rates and a commitment to keep them low for a considerable amount of time sent investors rushing towards non-traditional income assets and inflation hedges in 2011. Many dividend-paying investments including trusts shot up in price over the next year, often getting ahead of themselves. Investors eventually realized, though, that income from non-traditional sources can be less-reliable than from quality bonds. A few saw their income decline while others saw impairments of one sort or another cause the unit price to drop significantly. VOC experienced this drop in October of 2012 when it announced a markedly lower quarterly distribution due to a failed well that would impair distributable cash for the next two quarters. October's distribution would fall by 23.3% from the $.60 it paid in July. While the shares tried to rally in early 2013 they were knocked down again after seeing the remainder of the failed well expensed in the January distribution. The January dividend would fall an additional 43.4% from the already reduced October distribution. The unit price of VOC plunged in sympathy from a high of $19.38 to under $14 just two weeks later.
VOC's sister trust, MV Oil Trust (MVO), experienced similar negative performance in its early years. In 2007, the trust's first full year of operation, a harsh Kansas winter slowed production by temporarily shutting down a few fields resulting in a reduction in the payout. Shortly thereafter, the trust suffered a huge drop in price when the main buyer of its oil filed for bankruptcy and left the trust with almost no cash to distribute. This temporary setback took the price all the way down to below $7 from an IPO price of $21.50 just two years prior. However, MVO continued to collect revenues from production on their 1000+ wells. Once the setbacks were put in the past, MVO was able to rise as high as $43.53 in July of 2011, just two years later. Today it trades near $30 with a yield of just under 12% and a remaining lifespan of 13 years before the trust dissolves. VOC collects revenue from 881 producing gross wells (per the 2012 10-k filing). Though the trust was setback due to the failed well expenses, the remaining wells continue to produce.
VOC drilled no new wells in this last quarter, so there should be no unexpected hits to the quarterly distribution this time around. Additionally, the two wells that were spudded late in 2012 have now had a full quarter to produce and should contribution a small incremental amount to this quarter's distributable cash. If we look for a baseline of distributable cash from which to gauge future distributions, the September 2012 quarter brought in $10,200,000 after trust expenses and withholdings ($.60 per unit). The mean of the first nine months of 2012 is a slightly lower $9,800,000 on 17 million total units outstanding. This would result in a payout of $.576 per unit per quarter assuming no major changes in the price of oil (indeed, a portion of the trusts' oil for 2013 is already pre-sold at $99.01 which is higher than WTI spot rates). The trust averaged $91.41 per barrel in 2012 so I'm expecting a slight increase in distributable cash for the coming quarter, which should be announced around mid-April.
If we take a conservative approach and estimate $.55, that equates to a yield on capital of 16.9% when the trust is trading at $12.97. I already indicated that VOC's sister trust, MVO trades with a yield of just under 12%, and VOC has a lifespan of 4.5 years longer than MVO so it should command a premium to MVO if the past two quarters of disappointment were to be ignored. Investors will likely not ignore them, though, so I anticipate that VOC will trade up to a 14% yield after the announcement. That places a target of about $15.70 on VOC, or about a 21% gain from recent prices plus a very attractive yield. If VOC were to trade at a 12% yield like MVO, it could see $18.30 again. I believe it will take a second quarter confirming the $.55 distribution level to make that happen, so I'm focusing on the $15.70 target for now.
Primary risks to my investment thesis:
1) Future impairments are not expected, but can happen - as we have recently seen.
2) The market for these investments is very inefficient, so value often goes unrecognized for long periods of time.
3) The price of oil could drop substantially, so even if production levels remain stable, cash for distribution could decline taking the price of VOC down with it.
The inefficient and misunderstood royalty trusts are often subject to wide swings of over and undervaluation which is exacerbated by data mining analysts. The market for trusts was lofty and arguably overvalued when VOC came out as an IPO but has subsequently swung to significant undervaluation seemingly based upon an overreaction to a temporary impairment. VOC should see a return to normalized dividend levels this quarter and should see a commensurate increase in price as a result.
Additional disclosure: Clients of my firm are also long VOC and may continue to accumulate units.