We recently wrote an article on SandRidge's Permian Trust (PER) where we determined that the shares looked attractively valued at $14/share. SandRidge has two more royalty trusts and here we take a look at the Mississippian Trust II (SDR) where we find that these shares are also attractively valued and, in fact, even more so than PER. Our analysis indicates the SDR trust is offering close to a 15% yield but, as we'll discuss, there is more risk in SDR. In particular, the return structure is asymmetric with SDR's performance being more susceptible to downward energy prices. That said, we think the incremental return offered by SDR makes it a suitable candidate for risk-tolerant income investors.
SD's royalty trusts have been under pressure as commodity prices have come down as well as oil and gas reserves relative to initial expectations when the trusts were IPO'd. For example, at the end of 2011, SDR stated that they had 26.1 MMBoe of proved reserves of which 46% was oil, including natural gas liquids (NGLS), and the remainder natural gas (NG). In addition, they stated that they had 9.8 MMBoe of probable reserves. At the end of 2012, however, the proved reserves were revised down by 5.6 MMBoe being offset by an upgrade of 6.5 MMBoe from probable reserves; that is a pretty big move from probable to proved. Net of production, total proved reserves were 25.5 MMBoe, slightly down, but they did not state if any probable reserves remain. In addition, NG now makes up a larger percentage of reserves at 57% with "black" oil coming down to 28%. These revisions and uncertainty about the productivity of the Mississippian play, led investors to reevaluate the value of SDR. Lastly, last quarter's distribution was 11% below the target level set at IPO, and close to the subordinated threshold, even as production was nearly 7% above initial expectations according to our calculations.
We reverse engineered SDR's original production profile based on the information supplied in their 424B4, matching reserves, total undiscounted cash flows, and PV-10 using the same constant price assumptions and differentials, if any, as they did. Then by adjusting this profile, we produced a current estimate of what the production profile should look like going forward along with the distributions for common and subordinated unitholders. The new profile assumes that near-term production is 5% over initial levels, in line with last quarter, with a reduction over time so that total production matches proved reserves. Note, we give no weight to probable reserves given their lack of mention in the recent 10-K; let's consider it a bonus if they reappear. Using their pricing and cost assumptions, the production "decay" is set to match the undiscounted future net cash flows of $910 mn as well as the PV-10. Once calibrated, we modified the commodity prices to match recent and forward-looking prices from CME futures. In particular, we assumed a flat pricing of $85 for oil (inc. differential), NGLs at 35% of WTI, and NG at $4/Mcfe, starting in Q2, and incorporated their stated oil hedges.
Chart 1: Original Target and Estimated Future Distributions
The chart above shows our estimates for both common as well as subordinated units out until 2020. The subordinated units provide a buffer for the common so that if available cash is insufficient to meet the specific threshold (80% of original target), then subordinated shares suffer first. As can be seen, distributions are expected to be well below target levels that were set back last year. In addition, the subordinated threshold, which mimics the target profile, will likely be breached soon if commodity prices do not move higher. We see subordinated units continuing to suffer, in support of common shares, but never reaching the point of exhaustion. Near-term, there is significant protection afforded to common units from the subordinated shares. Longer-term, however, the reduced production profile and lack of further hedges, leaves little room for lower energy prices. Discounting the common unit distribution profile using a 10% rate, produces fair value at $12.80 per unit. At a 15% rate, fair value is $10.50. With the big move up in price today, the shares are offering about a 13% yield.
As we mentioned, SDR offers a higher yield than PER (about 3.5% more currently). Part of the reason could be that the Permian basin is more oily and seems better understood relative to the Mississippian. In addition, PER has more wells, more concentrated acreage (one county vs. nine for SDR), and a lower drill cost per well. The latter may be an important factor in light of SD's recent credit concerns. An additional factor, as highlighted in Chart 2, is the asymmetric return profiles of both PER and SDR. According to our model, PER has positive convexity with respect to energy prices. It performs measurably better on average, for the same absolute move in energy prices. If energy prices decline by 20%, PER would lose 8% in value but it would gain 12% if energy prices rise by 20%. In contrast, SDR has the opposite profile (negative convexity) in that SDR is more susceptible to lower energy prices.
Chart 2: Effect of Energy Price Changes on Fair Value
The reason for the two different return profiles for SDR and PER is "in the moneyness" of the subordinated option that common unit holders are long. In the case of PER, the distributions are fairly far away from the subordinated threshold so they receive incremental benefit as energy prices decline. On the other hand, SDR unit holders are already reaping the benefit (on a forward basis) so any rebound in energy prices benefit the subordinate unit holders first while declines in energy prices impact SDR's common units marginally more as the benefit of the sub-units runs dry. This is the reason that SDR units should yield more all else equal.
We think the value in SDR shares is attractive but there are some things that investors should consider. First, SDR and PER (as well as SDT) have the same underlying sponsor (SD) so the amount of capital one puts into these trusts combined should be subject to any name risk limits one has (e.g., we use 2-3%). In addition, we recommend that investors weigh more towards PER given the risk profile shown above. In fact, a portfolio of 65% PER and 35% SDR, flattens out the risk profile and produces a combined 10.5% yield. Given this is protected against energy inflation (in dollar terms), this real yield looks extremely attractive for income oriented investors.