Last quarter for SandRidge Mississippian Trust I (NYSE:SDT) was a "swing and a miss," for the third time in a row. On April 25th, SDT 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 but low NGL prices. However, SDT's distribution of $0.59 was 20% below target, and was so poor that the earnings on a fully dilutive basis could not cover the subordination threshold for the Trust - so the common units received the threshold distribution while the subs received less.
The lower distribution level should come as no surprise to anyone invested in the Trust. As the above graph shows, the distribution levels have shown a steady decline since the May distribution last year. This is the opposite of the projections in the IPO prospectus of the Trust, which expected distributions to rise throughout this period.
The Trust's press release references lower realized price levels and lower oil production as the cause for the miss. The market seems to want to shrug this poor performance off, not only in this Trust, but other Trusts, which are more concentrated in natural gas production. I give some rational credit to the gas price adjustment. However, it might be worthwhile to make sure the price level for the Trust shares can be fully rationalized against the comment about production - especially in light of the fact that drilling will complete in the coming quarter, well ahead of the original Trust schedule.
In the article I published in March, SandRidge Mississippian Trust I - Dramatic Decrease in Well Performance Shown in Reserve Report, I analyzed the Trust's proven reserve revisions as announce 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 17.7% miss, and the actual result was a 20% miss and the Trust could not even meet the subordination threshold. So, in this article I will review the numbers in light of the new quarterly information to see what is happening and give my opinion on how investors should be viewing the market valuation at the present time.
Earnings Performance Analysis
In the press release announcing the Trust's 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 sharp decrease in MBOE proven reserves of -17.9% during 2012 due to well performance and a shift in product mix in which oil was 43% of production, to an oil / NGL mix of 23.3% / 15%. This is a 4.7% reduction in liquid product production.
During the quarter volume was 364 MBOE, down from a high of 419 MBOE in the previous production period and also much lower than the 413 MBOE registered one year ago. The earnings generated by production throughout the entire year have also shown a major divergence from the MBOE volume since the early 2012 production time period.
This earnings pattern is indicative of much poorer well performance and most definitely means that there has been much lower price per MBOE products contained in the Trust's production mix since production dating back to May of 2012.
In the graphic below you can see that drilling has been accelerated by SandRidge (NYSE:SD), well ahead of the IPO schedule. The Trust's drilling is expected to be complete by this production quarter.
Drilling completion in this quarter means that subordination will end by the August distribution in 2014. The IPO prospectus projected that the end of subordination could take as long as the end of 2016. Based on drilling completion the 2nd production quarter of 2013, unit subordination will end over 2 years ahead of the worst-case IPO schedule.
The SandRidge earnings call did make a statement, which is indicative of the new management's attempt to clean up the mess at the operator from the past year's performance:
They state in the release: "a higher proportion of capital [will be] directed toward drilling producing wells. This focus on capital efficiency has resulted in a reduction in the capital investment budget for 2013 and an extension of the company's liquidity…"
There are a couple of interpretations I can make from this statement. 1) The drilling operator is saying that 2012 did not produce very good well results, but Q1 in the Mississippian Play was better. The poor 2012 wells seem to be showing up in the SDT numbers this past quarter and the 12/31/12 PV-10. 2) More prudence will be taken in the drilling going forward in order for the operator to conserve capital and achieve a better rate of return; too late for SDT, but it might benefit other SandRidge Trusts such as (NYSE:SDR) and (NYSE:PER).
As an investor, the accelerated drilling plan at SDT combined with earnings levels indicative of even poorer well performance than previously estimated is not a good thing for the common unit holders. Based on this information, it appears further downward revisions in the estimated future distribution rate are necessary to fairly value the Trust at this time. I will go through this in more detail in the following sections of this report.
Production Mix Analysis
The PV-10 published in the most recent SDT 10-K made a major adjustment in the trust production mix. As shown in the graph below, the oil & gas mix was split into component oil / NGL / gas parts, and also the oil and gas mix was shifted from 43 / 57 to 38 / 62, a substantial change.
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, the gas mix is not only as high as the most recent PV-10, but even higher. The trend is indicative of a potential revision in production mix going forward to more concentrated gas production.
The market price for oil and gas also impacted the Trust's quarterly results, and may have had some bearing on lower oil sales during the quarter. 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.
The average realized price at the Trust was $45.43 in the November to February production quarter. This is slightly higher than the $45.13 the prior quarter. As the market prices reflect, the big downward change in the realized price level at the Trust occurred 3 quarters ago - when both oil and NGL prices declined. This was also the point in time that the production mix saw a substantial upward move in gas mix of 5%-7%.
Doing the math on the shift in mix, using the graphic below for realized prices, I have broken out the following impacts on Average price:
Year over Year Impact Due to Mix Change: ($5.28) which is -9.83%
Year over Year Impact Due to Price Only: ($3.01) which is -5.60%
Qtr over Qtr Impact Due to Mix Change: ($0.21) which is -0.46%
Qtr over Qtr Impact Due to Price Only: $0.46 which is +1.02%
The majority of the quarterly result deterioration of the Trust is due to the shift in mix to more natural gas. A $.51 per mcf improvement in natural gas price in the past quarter only produced a 1% improvement in overall realized average price level. It would take a substantial change in natural gas market price levels to recover the loss, which has resulted from the mix change since this time last year.
The Trust has oil hedges in place for a substantial portion of its oil production at $101 through December of 2015. It also carries hedges on approximately 25% of its natural gas volume. The realized price levels contain the benefit from the hedges as well as the differentials for delivery of production. The Trust forecasts a differential of approximately $5.00 in the oil price realized and the oil hedge price due to delivery basis risk. The trust oil production is estimated to be 78% WTI and 28% WTS, and the widening spread between WTI and WTS in the last production quarter did show up in the $96 realized price level. But the total impact was not out of line with typical quarter expectations, and not nearly as detrimental from a price realized standpoint as what happened at the SandRidge 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 gas price hedge was supportive, although a substantial amount of the production volume is not hedged. If natural gas prices continue to go higher, the realized price level at the trust will improve. Currently a $.50 move up in gas prices is giving a 1% move up in realized average BOE price levels.
The hedges expire in December 2015. Presently the forward price curve for oil is in the $87 dollar range in 2016, and for natural gas it is slightly above $4 at a range of $4.16 to $4.56 depending on settlement contract month. So, the forward expectations for production sales price levels in the years beyond the current hedged production at the Trust show risk in the oil price curve, and generally high probability the natural gas delivery will be above $4 per mcf. (These prices do not reflect the Trust specific negative differential for underlying product delivery.) As hedge expiration gets closer, this risk will need to be continually monitored to adjust expectations.
In the Trust 10-K published in early March the year end PV-10 was supplied which showed a per share value of $8.36 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 $7.99 per unit share.
Some details about the PV-10.
- The composite average price level net of expenses to get this PV-10 estimated value is $34 per BOE at the price assumptions shown above and NGL at 15% of the production mix. The delta with the current realized price level of $45 is largely due to the Trust oil hedge, which is keeping actual realized prices higher than market and a lower natural gas price level used in the PV-10, which drags down the PV-10 value.
- If the natural gas price averages $4.12 rather than $2.24, which may be a better long run estimate based on the current futures pricing curve, the estimated adjusted PV-10 would be $9.93, assuming oil prices are $90.57 per barrel.
PV-10 Trust Comps
The current PV-10s of the Trusts that I track (NYSE:CHKR) (NYSE:ECT) are shown in the table below, and as you can see, the SandRidge Mississippian Trust I is trading at a price point that is 1.78x its adjusted PV-10. The SDT production mix is generally higher on average in natural gas mix, and is trading in a range, which is comparable to the Chesapeake Granite Wash Trust. Currently 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 SDT 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 forward price curve for oil seems to be lowering the current market value of the oil heavy Trusts in comparison to SDT.
Trust Fair Value Estimation
In my previous valuation of SDT, I used a discounted distribution model, which adjusted the expected target distributions, which were provided in the Trust IPO prospectus. The distribution adjustment factor that was utilized was -17.7%, which was derived from a thorough analysis of the 12/31/2012 PV-10. The adjustment factor, however, did not completely hold up in the recent quarterly announced results. This led me to do a more in-depth review of the actual distribution model used in the IPO prospectus. Based on this review, primarily because of the number of base case assumptions that could not be rationalized in today's market, I determined that a better approach in the case of this Trust is to move to a model where the inputs reflect current market conditions, and can be adjusted more easily as information becomes available.
The table below summarizes the information used in the model to derive a go forward distribution forecast:
The assumptions model uses the forward price curve for oil and gas prices combined with the Trust hedge contracts through the end of 2015. Post hedge the model uses a market price base on futures price levels. The out year price levels are grown at a rate of 2.5% annually up to a cap level, which in this model are not reached before Trust termination. All prices are adjusted for delivery based on the average differential, which is typically realized by the Trust.
The model also uses a product mix of 35% oil and 65% gas which is slightly less oil rich than the current PV-10 in order to capture the current trend line in well production.
When the price and mix assumptions are combined with the current proven reserves remaining at the Trust and the expected production curve, the forward distribution model can be forecast as shown in the table below:
Based on this model, at the opening ex-dividend price level of $13.97 on 5/13/2013 the implied rate of return on the Trust if bought and held to termination is 9.9%.
If you expect a 15% return, a fair price level is $10.98.
This valuation model downgrades the value of SDT from the last quarter, primarily because of the deteriorating trend in the production mix, which is lowering the expected distribution stream to SDT unit holders. The model last quarter discounted the IPO target distribution level on average by -17.7%; this model on average lowers the expected distribution stream forecast at IPO by -21.2% over time. As shown earlier in this article, the earnings of the Trust were down over 20% from the level needed to cover target distribution levels, so at present this model is much more in-line with current market conditions.
The SandRidge Mississippian I Trust is struggling from an earnings performance standpoint, and in my opinion is over-valued in the market at a $14 price level. In the coming quarter drilling will be completed, and the subordination protection to common unit holders will end 4 production quarters hence, well ahead of the original forecast. Additionally, the production mix has changed dramatically over the past three quarters, which brings into question the performance of the recently drilled wells. Because of the growing risk level at the trust, a higher discount rate on forward distributions is warranted.
My fair market estimate at this time is $12.50.
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