On April 25th, SandRidge Mississippian Trust II (SDR) 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, as with many of the Trusts that I track, SDR's distribution of $0.56 was 14% below the target of $0.65:
The lower distribution level was not unexpected. In the previous quarter, the first signs of lower than expected results were evident in the first target miss by the Trust, and the lower earnings performance carried over into the winter months. Inclusive of the current quarter, the Trust has a 97% track record of meeting its target, which is relatively high compared to other Trusts.
In the article I published in March, SandRidge Mississippian Trust II Good News Buried In Proven Reserve Report, I analyzed the Trust's proven reserve revisions as announced in the published 10-K. Based on this report, I was not expecting the Trust to be able to meet the IPO target this quarter. In fact, I was expecting a 15% miss, and the actual result was a 14% miss, hurray. But here is the good news that I will present in this article - the underlying results were not that bad during the quarter, and there remain signs that the Trust relative to its peer group is a good risk-reward value.
SDR Earnings Performance Analysis
In the press release announcing the Trust results, management pointed to "lower oil sales volume" than the estimate in the IPO Target as the reason that the distribution target was missed. This was not unexpected given the PV-10 which showed a shift of oil production estimated in the IPO prospectus at 46.2% of production, to an oil / NGL mix of 28.2% / 14.7%.
The interesting part of SDR's announcement, however, is that a big shift downward in the earnings line is not readily apparent due to lower oil sales, other than the impact of lower sales volume overall - a stark contrast to other Trusts that I track. During the quarter, volume was 518 MBOE, virtually the same as the prior quarter, but down from a high of 557 MBOE last summer (Nov-12 distribution is for May-Aug production). The earnings generated by production throughout the entire last year have been relatively predictable based on the MBOE volume, with the past quarter showing a slight improvement in earnings per MBOE. Looks to me like the Trust has had this production mix all along, and the IPO prospectus was incorrect…
In sum, although the management statement says the distribution target was from lower oil sales than in the IPO prospectus, from a sales mix standpoint, there is no evidence of a reduction in relative oil sales volume - oil sales in the product mix have been virtually static since the trust inception from a numbers' standpoint. In fact, as I will show below in this article, in the past quarter, oil was actually a higher percentage of total sales.
In the graphic below, you can see that drilling is progressing at a brisk pace, ahead of schedule. At the present pace, which is 20 wells per quarter, the Trust drilling will be complete by mid-2014.
Presently, I estimate that subordination will end by the August distribution in 2015. The IPO prospectus projected subordination would end at the end of 2016. If the current drilling schedule is maintained, subordination will end 1 quarter ahead of the IPO schedule. The SandRidge (SD) earnings call did show a substantial reduction in capital expenditures in the coming year. This could have a minor impact on the pace at which the wells are being drilled at the Trust in the coming year.
As an investor, accelerated drilling can be a good or bad thing. It is good from the standpoint that you can more quickly get a payback of your initial investment if the selling price for the oil and gas is high, and the production volume increases. However, if accelerated drilling is to cover for poor well performance results, this can be an unfavorable indicator. All it does is accelerate production near-term, before the subordination period expires, and then when drilling completes, there is a much bigger cliff down which production falls. At this point, SDR, as with most of the Trusts that I follow, is on the "get the drilling done quickly" path and a lot of the increase appears to be linked to wells which are lower in capacity than expected - combined with cash starved operators who may want to be in a position to sell properties more quickly to raise cash. In the case of SDR, there is probably a bit of this going on, but I would not yet place it at the unexpected level. The acceleration of wells will affect the distribution stream. I expect it to support near-term distribution levels through the end of 2014, and beyond this point, there will be a sharp decline for a year before leveling off.
Production Mix Analysis
The PV-10 published in the most recent SDR 10-K made a major adjustment in the trust production mix. As shown in the graph below, the oil and gas mix was split into component oil/NGL/gas parts, and also the oil and gas mix was shifted from 46/54 to 43/57, a fairly substantial change given the present prices in the energy market.
In the graph, I have also plotted the natural gas and oil percentage mix over the last year to see if the trend line is actually reflecting a shift to natural gas. As the chart shows, at least for the last quarter, the 54/46 production mix seems to still be more reflective of the underlying property. This is in-line with the drilling operator's quarterly earnings report which stated that "Mississippian Quarterly Production Grew to 39.5 MBoe per Day (46% Oil)." The oil percentage is a good indicator of the production being realized on the SDR wells being drilled.
The market price for oil and gas also impacted the Trust's quarterly results. In the graph below, you can see the actual market prices for oil, gas and NGL during the past year and the last production period.
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 relative to oil 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.
During the quarter, the Trust saw a realized price increase of 4.4% quarter over quarter as shown in the graphic below:
Better gas prices during the production period helped the Trust realize a higher per BOE price. The impact was $1.62 of the total $2.44 upward change in realized prices. The remainder was the mix shift to oil of 1.7% at an average price of $99.46 (down from $101.20 in the prior quarter).
The Trust has oil hedges in place for a substantial portion of its production at $102 through December of 2014. On average in 2013 the Trust has 264.5 MBOE of production hedged per quarter at a price of $104. Actual oil production, including NGL during the last production quarter was 235.2 MBOE. So, why is the realized price not higher since an estimated 100% of the volume produced is hedged?
I do not have data on how the contracts are weighted in any given quarter, but even if the winter quarter was slightly less, I estimate the Trust was still fully hedged. The reason for the difference in the $104 hedge price, and the actual realized price of $99.46 lies in the pricing patterns in the underlying markets for the products that the Trust delivers, and the point at which they deliver the products. Most likely the majority of the differential basis risk of $4.54 on the oil hedge contract is explained in the differential spread of NGL to oil in the production quarter, which widened to 2.6:1 in the production quarter. The typical hedge assumes a 2:1 differential. At this ratio, an estimated $4+ delta on a $104 underlying oil contract would have resulted last quarter if NGL comprised 20% or more of liquid production volume. The differential may also have been attributable to the underlying oil product delivery point and type of oil product delivered, but this does not seem to be the likely issue with SDR as it was in the case of the Permian Trust. (I explained the "differential risk" issue in detail in the recent article - SandRidge Permian Trust Shares Recovering After Differential Disaster Last Quarter ).
The level of differential between the realized price and the hedge contract points to several issues for investors in SDR. First, the underlying market for NGL products is over supplied as production in the natural gas market, which was over supplied a year ago, has shifted to liquids to stabilize the natural gas price. It has worked so far for the natural gas market, but to the detriment of NGL pricing. The second risk is what happens in 2015 as the Trust's hedges expire. This issue will require diligence a year from now.
In the Trust's 10-K published in early March, the year end PV-10 was supplied which showed a per share value of $9.80 for the expected cash flows from the remaining proven reserves held by the Trust, discounted at 10%.
I have updated the PV-10 for the production volume at the Trust since the PV-10 was completed. The adjusted PV-10 is $9.44 per unit share.
A few things about the PV-10.
- The composite average price level net of expenses to get this PV-10 estimated value is $42 per BOE at the price assumptions shown above and NGL at 14.7% of the production mix.
- If the natural gas price averages $4.12 rather than $2.24, which may be a better long run estimate, the estimated adjusted PV-10 would be $11.00.
PV-10 Trust Comps
The Trusts that I currently track, PER, SDT, CHKR, ECT, are in the table below, and as you can see, the SandRidge Mississippian Trust II is trading at a price point that is 1.37x its adjusted PV-10. The SDR production mix is more evenly split between oil and gas than the other Trusts. On the other hand, the natural gas heavy trusts are trading at a much higher multiple. To some extent, it is warranted, as I have shown in the calculation which adjusts the PV-10 calculation for SDR based on expectations that pricing returns to a $4 per mcf pricing level.
Product Mix: (Oil%/NGL%/NatGas%)
Currently, the market is not trading the oil portion of trust production at any significant premium to PV-10. This is most evident in the PER valuation, and also shows up in the lower multiple at SDR. 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 natural gas 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.
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 June 2023 for oil and natural gas rising to $7 through Trust termination.
The oil price assumptions are fairly common across the Trusts that I review. The natural gas price assumption, however, is conservatively low by comparison in terms of the implied price growth.
The distributions also were based on a production mix of 46.8% oil, 53.2% natural gas and a certain well performance expectation level. The mix and well performance have been adjusted since the IPO.
To estimate the relative impairment to the expected distribution stream going forward due to well performance and proved reserve changes, I have used the PV-10 data and I have also derived the implied production curve embedded in the IPO distributions by using the target price assumptions in order to understand how the new mix will affect distribution levels under the implied price curve assumptions. The derived impairment figure is currently -16.89% since IPO. This estimate is a slight downward change from the -15.7% estimate from last quarter due to more in-depth study on the impact of the production mix change.
Trust earnings have been off by -12.8% for the trailing two quarters. Therefore, the -16.89% adjustment downward from target is high in the near term. The reason the Trust should beat the adjustment factor near term is that the drilling is ahead of schedule. Over the life of the trust, however, near-term acceleration of MBOE sales will result in lower distributions longer term.
Taking the current $12.92 market price of the Trust on 5/3/2013, and adjusting the future stream of Trust target distributions on average by (16.89%) starting with the next distribution through Trust termination, the implied rate of return of a Trust unit held to Termination is 14.80% (before tax return).
Everything has a price, even if the way it was initially presented is not what it truly turns out to be - just make sure the price paid reflects the risk taken. In my opinion, the SandRidge Mississippian II Trust is a good risk-reward value at the current market price of $12.92, implying a 15% rate of return. The Trust has favorable hedges in place for oil production and is likely to provide distributions that will be about 90% of the IPO target through the end of 2014, which is a payback of 42% of the initial investment in just 2 years. The quick payback greatly reduces the duration of the investment. I expect a distribution of $.61 next quarter on production of approximately 550 MBOE. If this occurs, it will still be below the IPO distribution target level, but an increase in overall Trust earnings relative to last quarter of 10%.
I also expect that in the remaining quarters of this year, an investment which has a low duration and high inflation hedging characteristics like SDR will increase in investor demand due to the non-stop Federal Reserve quantitative easing policy. At present, the SDR share price has some built in forward commodity inflation in the price, but does have some pricing upside due to the high implied rate of return of 15%. My advised price range for the trust is currently $13 - $15.
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