Anyone following the U.S. Royalty Trust market in the past week has seen a major rally underway. This is particularly true in the case of the SandRidge (SD) Trusts that I follow. In this report I will provide a research update on the SandRidge Permian Trust (PER) to provide current investors and potential investors information about what happened in the most recent quarter, why the results were unimpressive, a "disaster" on a relative market basis, and how the information relates to the current estimated fair market value of the Trust.
This sector as a whole is receiving more attention at the present time. It is not surprising given the shorter duration nature of this type of investment, its longer term inflation hedge potential and its high rate return pricing in a Fed driven world where "junk bonds" are trading at 5%.
Announced Quarterly Distribution Payable in May
On April 25th the Trust announced its quarterly distribution for production during the time period December 2012 through February 2013. During the winter months the general market showed oil prices which were relatively high throughout and generally rising natural gas and stable NGL prices. However, the Permian Trust was not experiencing any joy, as the graphic below shows:
The $.51 quarterly distribution announced was fully 20% below target, and the Trust earnings were insufficient to cover the threshold distribution level for all shareholders for the period. This was in sharp contrast to the record of the Trust, which since inception has been able to meet or exceed the target distribution level a majority of the time. Inclusive of the current quarter, the Trust has a 99% track record of meeting target, very high compared to other comparable Trusts.
So, what went wrong? In the limited and cryptic information provided in public statements, the Trust spokesperson said the issues were "differential widening" and "late completion of drilled wells." Many investors in these Trusts probably have no idea that they have "differential risk", and don't feel bad if you don't know what it means. Even if you do, there is not much you can do about it. In brief, the issue is that the Trust hedges its of crude oil in WTI for Cushing delivery, but has substantial production of different product types -- WTS, NGL. This type of hedge protects the Trust from general market price volatility and declines, but if the products it is delivering become highly uncorrelated from the general WTI market contract price, the "difference" in the price level between the markets flows through as a price risk to the Trust. In the most recent production period, the spread between the WTI and WTS market for Cushing, OK delivery was at historic high water marks. Additionally, the NGL market relative to the WTI crude contract was at a wide spread.
The Trustee did provide some brief but good information that the risk subsided in March, which means the next quarter should show some improvement -- but probably not full recovery. The late well turn-over is understandable given it was wintertime. But it might seem more logical that the issue was slack overall market demand in a market that is seeing a rush of new supply from well development -- which in turn encouraged a decision to hold off production.
Let's go through the details a little more closely to see what is actually going on.
Trust Earnings Performance Analysis
Even though the management pointed to price basis risk as the primary earnings issue, the first thing I wanted to know after seeing the poor distribution announcement was what happened to production. During the quarter MBOE volume was 341 MBOE, 12.8% below expectations. The production volume has never been this low since the inception of the Trust in August of 2011. In other words, even though many new wells may not have turned on until late in the quarter, there are far more wells in production now than when the Trust began, so, lower production due to late well turn over is not likely the whole story. Lower demand would be a preferred answer -- a worse outcome is poor well performance. In the PV-10, there was a 6.5% reduction in long term production due to "well performance and price risk". This production drop is indicative of a scale back in production levels going forward due to adjust to market over-supply conditions.
In the graphic below you can see that drilling is progressing at a brisk pace, ahead of schedule. It is however, being scaled back to a slightly slower pace than it was running in the year since IPO. At the present pace which is 54 wells per quarter, the Trust drilling will be complete by the end of 2014. Presently I estimate that subordination will end by the May distribution in 2016, 6 months ahead of the IPO schedule.
Overall, Trust earnings of $24.8M fell by 21.7% quarter over quarter. The production drop accounts for 12.8% of this drop. Production being lower can be explained somewhat from the management statement that new well production was not turned over until late in the quarter. But well performance, and slack market demand were very likely also contributing factors.
Realized Oil & Gas Price Impact Analysis - Differential Disaster
To see the magnitude in the decrease in realized price received buy the Trust for its production volume during the last quarter, I have prepared the table and graph below.
The total price decline for the quarter of production was (8.05%), which when combined with the (12.85%) in production volume, accounts for a total decline in Trust earnings of (21.7%).
The Trust has oil hedges in place for a substantial portion of its production at $101. On average in 2013 the Trust has 322 MBOE per quarter of production hedged. This translated to 94.5% of production in the last quarter or virtually the entire quarter of oil and NGL production, assuming the average (I do not have a way to see if the contracts were weighted in any given quarter). The realized price level per barrel equivalent of oil volume during the quarter was $83.28, and total production realized price was $80.08. The reason for the difference in the $101 hedge price, and the actual realized price lies in the pricing patterns in the underlying markets for the products that the Trust delivers to the market, and the point at which they deliver the products. The Trust delivers production which tracks the price of WTS and WTI-Midland, but the hedges are for WTI-Cushing delivery. These product markets are not perfectly correlated; therefore, the price difference between the markets overtime is a direct risk of the Trust.
Production Mix Analysis - Uncovering the Differential Risk due to NGL
In order to analyze the magnitude of the basis risk in the Trust due to NGL you have to dig into the 10-K report earlier this year. In the PV-10 reported in the 10-K, the Permian Trust shows a breakdown of its production, including its NGL production in the oil mix. This number is 10.5% of production as of Dec-12. It was actually down slightly as a percentage in the last PV-10, as was natural gas in the mix. So, on a relative basis, you might expect that the risk of pricing being impacted by NGL should have been going down. In the December to February quarter, however, this was not the case.
As the above graphic shows, oil prices (WTI-Cushing) trended higher during the latest production period as did natural gas. However, NGL prices (Propane - Mont Belieu delivery used as proxy) on a relative basis declined in the quarter, and the spread widened to 2.6:1. This affects the realized price level in the Trust in several potential ways. To the extent the Trust hedges NGL production, it is probably doing so on a 2:1 basis -- 1 WTI contract to cover production of 2 BOE of NGL. When the spread widens beyond 2:1, the spread in pricing between the markets is direct price risk of the Trust.
To the extent the Trust has non-hedged production, the lower NGL prices, of course, translate into lower realized prices.
I cannot tell exactly how much the Trust has hedged NGL production. The hedge analysis shows about 86% of expected production is hedged through Sep-15. In this quarter, since production was so low, it was most likely closer to 100%. So, most of the pricing impact in the last quarter from NGL was from a higher basis spread between the WTI-Cushing and NGL market.
Differential Risk due to delivering WTS while hedging using WTI contract
To visualize the dramatic spread increase between WTI and WTS for delivery at Cushing, OK during the past production period, I have prepared the following graphic:
The data time series shows how the spread widened to $16 in both January and February of 2013, and averaged $14.40 for the period Dec-12 thru Feb-13, and $10.82 for the period Nov-12 thru Jan-13. Depending on the exact timing of the Trust production deliveries, the basis risk for the quarter was most likely in this range.
This high differential between these markets is historic. Looking at the data back to the beginning of 1994, there has been only one month where the spread averaged over $10 -- Mar-06. And the three month average spread was never above $10 over that time period. The spread level is also interesting because it comes a year after the differential was at a relatively low historic level of $2.58 for the 3 month production period of Nov-11 through Feb-12. This was a big contributing factor in the Trust being able to achieve a high realized price level of $90.04 a year ago.
The spread level in current history since 2004 has been $5.57, which is probably a reasonable expectation for the market to return to over the near term. There are factors that will aid in lowering the spread. One issue that is noted as a big contributor to the large spread is the pipeline constraints for delivery of oil to different markets. With the mini "oil boom" going on in the Midwest at the present time, it is not surprising that infrastructure is being stressed. And Cushing is one of the stress points for oil being produced in the Permian Basin. To alleviate the supply overhang from the Permian Basin, there are pipelines which are being brought on-stream such as the Longhorn Pipeline owned by Magellan Midstream and West Texas-Nederland pipeline owned by Sunoco Logistics. This will lower the spread issue as production will be able to find its way to different delivery markets and lower the overall spread across markets. This may work to lower the general market price relative to Cushing, and will help the Permian Trust whose primary risk is in the spread through 2015. Beyond that point, if the Trust does not lock hedges at a price point of $101 or higher, the general market price for oil will become an issue post Q1 2015 if the market remains over-supplied.
Summary Price Impact Analysis
The table below summarizes the sensitivity of the Permian Trust to commodity price basis risk over the past year:
Over this time period the WTI to WTS spread went up from a 3 month average of $3.08 at the end of 2011 to $14.11 for 3 months ending Feb-13, a difference of $11.03. During the same time period, the average realized price at the Permian Trust declined by $9.96 -- almost a one for one correlation. Based on the price levels for the time period, I have estimated the amount of the price change that is attributable to each of the products. Not surprisingly, since oil is 84.7% of the mix, it accounts for 77% of the price swing, and NGL for the remainder. Natural Gas is such a low portion of the Trust product mix that even though prices rose over the period, the impact was minimal.
In the Trust 10-K published in early March, the year end PV-10 was supplied which showed a $13.39 per share value for the expected cash flows from the remaining proven reserves held by the Trust, discounted at 10%:
I have update the PV-10 for the production volume at the Trust since the PV-10 was completed. The adjusted PV-10 is $12.92 per unit share.
A few things about the PV-10.
- The price level used in the PV-10 was $90.49 for oil, and the PV-10 uses the product mix as shown earlier in this article which has 10.5% NGL and 4.7% Natural Gas. However, the details of the assumptions underlying the PV-10 price adjustments relative to oil are not in the public record to my knowledge. I have done an analysis to estimate the underlying assumptions, and they appear to conservatively track the price of WTS oil and NGL at the current much wider spread to oil. The composite average price level net of expense per BOE to get this PV-10 estimated value is $68.
- The PV-10 now shows adjustments to proven MBOE reserve levels for lower well performance and price levels going forward of -6.76% since the Trust IPO. I utilize this data in making adjustments to expected distribution levels going forward in the overall Trust valuation.
PV-10 Trust Comps
Before I get an onslaught of comments about how the PV-10 is not a fair way to compare Trusts, I will say, mileage may vary -- but you still need to review the universe around you in order to make sure the current price is grounded in reality. The PV-10s are done to a standard measure, and therefore have very important data which a public investor can get information that otherwise would not be available for judging fair value.
The Trusts that I currently track (SDR), (SDT), (CHKR), (ECT) are in the table below, and as you can see, the Permian Trust is trading at a price point that is a 1.12x its adjusted PV-10. This indicates to me that either the market does not believe there is significant upside potential in the price levels in the oil market above the PV-10 oil price, or that there is some skepticism about the Trust's proven reserves. It is most likely the forward oil market price curve.
Product Mix: (Oil%/NGL%/NatGas%)
The Trusts which have a much higher concentration of natural gas in the product mix are selling at a much higher multiple to the PV-10. This is not surprising because the price level for NatGas when the PV-10s were done were at very low market price levels. Since that time the realized price levels have improved, and are still expected to trend higher. However, I would warn investors to not overpay for hope. The Natural Gas market is historically very volatile, but more importantly it is also seeing a large increase in supply from recent exploration and the use of fracking technology.
Trust Fair Value Estimation
The table below has been developed by looking at the expected target distribution stream which was projected at the Trust IPO. The target distributions at IPO assumed a forward price curve for gas and oil rising $2.5% to $120 in 2023 for oil and natural gas rising to $7 in 2022. (click to enlarge)
The distributions also were based on a production mix of 87% oil, 9% NGL and 4% Natural Gas and a certain well performance expectation level. These assumptions have been adjusted since the IPO.
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 -6.76%.
At the current price of the Trust of $14.47, and adjusting the future stream of Trust target distributions on average by (6.76%) starting with the next distribution through Trust termination, the implied rate of return of a Trust unit is 14.3% (before tax return).
In my opinion, even with the "differential disaster" at the Permian Trust in the past quarter, at $14.47 the valuation model still shows Permian to be a good risk-reward value. The differential spread issue should abate in the coming quarters and production levels will be higher through 2016. The valuation model expects a distribution of $.62 next quarter on production of approximately 400 MBOE. If this occurs, it will still be below the IPO distribution target level, but a large increase in overall Trust earnings relative to last quarter. The Trust can beat the model expectations if the spread contracts more than currently anticipated and the realized price level returns to the $85-$86 level.
I expect that in the remaining quarters of this year an investment which has a low duration and high inflation hedging characteristics like Permian will increase in investor demand due to the non-stop Federal Reserve quantitative easing policy. At present, the Permian share price level reflects very little forward commodity inflation in the price -- it is trading close to the static price PV-10. My advised range for the trust remains at $14 - $17. If it rises above $17, hold but do not chase. Eventually the Fed will reverse policy -- not a question of if, but when. When the Fed changes course, you don't want to be left holding an over-valued risk asset. At current prices, this is one of the few traded assets I can find that still appears fairly valued.
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