Last quarter for Chesapeake Granite Wash Trust (NYSE:CHKR) was interesting because it provided a range of areas that showed change, mostly in a positive direction. But it was still an ugly quarter, so I will get that part of the report out of the way first.
On May 9, CHKR announced its quarterly distribution for production during the time period December 2012 through February 2013. CHKR is heavily weighted in production to natural gas so favorable trends in natural gas prices would lead one to expect a decent quarter for the Trust given the low levels gas prices reached over the past year. However, CHKR's distribution of $0.69 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. On a fully diluted basis the distribution was $.59, which was 32% below target -- so the subordinated units of the Trust (all held by Chesapeake) received a distribution that was substantially lower.
The lower distribution level is not a surprise, because it has become the new normal for the Trust. As the above graph shows, the distribution levels have been below the IPO target for the past five quarters. The rise since August 2012 is not a function of better performance -- it is only a function of the subordination threshold, which is 80% of target. On a fully diluted basis, the past four quarter distributions have been the subordination threshold amount.
The Trust press release references lower total sales volume and realized price levels as the cause for the miss. The market share price leading up to the announcement was positive, and there was no reaction to the announcement -- which likely means that the actual results were not a surprise, and there are other factors that are specific to the Trust as well as general market trends that are currently positive for share demand. The overall market rally, to the extent it is caused by Federal Reserve policy, is an impact that an investor will have to judge relative to their overall portfolio. I personally believe it is distorting the pricing of risk since about mid last year, and have written on the topic. But at the moment, this type of distortion is not likely to break if investors are waiting for it. The best strategy at this stage is not to overpay for risk and "hope" for any individual holding in your portfolio.
The specific areas that I see affecting the expectations for future Trust performance are what I will focus on in this article.
Review of Recent Market Impacting Events
In the article I published before the opening trade on March 20, "Chesapeake Granite Wash Trust - Updated Reserves Show Major Downward Revision, Buyers Beware," I analyzed the Trust's proven reserve revisions as announced in the published Dec. 31, 2012, 10-K. The day this article was published the information was not yet priced into the shares, and the shares fell from over $17 to slightly below $14 in two trading days. This over $3 gap down in share price provides a good indication of the market expectations of how big a negative impact the reserve revision would have on the future value of the Trust.
Since that time, the shares traded sideways until mid-April, and then began a 20% retracement back to the level it was just before the information about the revision to Trust reserves became public. A part of this rally is correlated with the S&P, which is up 8% over the same period. But the out-performance needs some additional explanation. There are some positive signals regarding the initial revision. The Trust CEO announced on May 9 that by drilling only three wells per AMI section instead of four, well performance loss on wells yet to be drilled is possibly mitigated. This means that at least on the remaining wells the issue may not be as bad as expected. So, maybe there is a rational for hope, at least on the remaining undrilled wells, and is in my assessment the likely reason shares have recovered since mid-April.
So, how do you evaluate all of these moving parts and assess the current share price? This report will provide information to fairly assess the situation for yourself and provide my assessment of the value of the Trust at this time.
CHKR Earnings Performance Analysis
In the press release announcing the Trust results, management pointed to "lower sales volume and realized prices" 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 -26.6% during 2012 due to well performance. During the quarter volume was 942 MBOE, down 7.6% from a high of 1020 MBOE in the spring production period in 2012 (current quarter distribution is for prior quarter production), and also 4.3% lower than the 984 MBOE registered one year ago.
The earnings for the most recent quarter, however, did not track lower with production -- which is a relative good sign. My review of the results show that realized prices in general were positive for results. Any statements about realized prices are only indicating that the price level was not as good as it could have been, primarily due to the continued low NGL price and the wide differential spread to oil. But overall, the earnings line is restrained largely by lower production, which to the extent it is not caused by decisions to hold product off the market, is a result of lower well performance, which is not recoverable in the future.
In the graphic below you can see that drilling has been accelerated by Chesapeake (NYSE:CHK) ahead of the IPO schedule. The Trust drilling is expected to be completed by the end of 2014.
Drilling completion in December 2014 or early 2015 means that subordination will likely end starting with the August distribution in 2016. The IPO prospectus projected that the end of subordination could take as long as the June 2017 quarter. The biggest news with respect to drilling during the quarter was the remedy Chesapeake is using to mitigate the well performance issue on future drilled wells with respect to the problem encountered with drilled wells that have gone into production, and wells conveyed to the Trust. The statement about the well performance issue during the earnings call was as follows:
The changes to previous estimates were primarily as a result of higher than expected pressure depletion within certain areas of the Granite Wash AMI. To mitigate this issue we are evaluating the benefits of drilling only three wells per section rather than four wells. Preliminary results while early have been encouraging.
The Trust has 45% of the total wells that Chesapeake is responsible to drill still remaining to be drilled. The undrilled wells represent 28% of the total wells the Trust expects to have in production at the end of drilling.
10-Q Statement about the Impairment
Here is an excerpt found in the accounting notes from the 10-Q published by the Trust on May 8, 2013:
Impairment of Royalty Interest. During the quarter ended March 31, 2013, the Trust recognized a $32.9 million impairment of the Royalty Interest. The impairment was the result of reserve revisions that were due to current results being below expectations, primarily as a result of higher than expected pressure depletion within certain areas of the AMI. This has resulted in lower initial production rates and lower expected ultimate recovery in certain recent development wells.
A couple of analytical notes for investors:
- The $32.9M write-off in book value of the Trust Investment is lower than the PV-10 downward adjustment on a relative basis. The write-off represents 6.75% of the $487.8M Investment in the royalty interest made by the Trust at IPO.
- The Dec. 31, 2012, PV-10 reduced the proven reserves by 11,756 MBOE on a conveyance of 44,266 MBOE or 26.3%, netted to 22.8% if you add discoveries and extensions in 2011. On a relative basis, one would expect that the write-off of the Trust Investment would need to be of similar magnitude. However, it appears the Trust has only written off the degradation to proven reserves associated with the wells already in production -- leaving a portion of the downgrade to be determined based on the mitigation plan results.
- One thing is certain, about 7% of the proven reserves invested in by the Trust are considered non-recoverable (and contrary to accounting jargon about being non-cash and not affecting distributions, it is a non-cash write-off that you can expect will reduce cash distributions going forward). The rest of the write-off depends on the performance of the 53 remaining wells to be drilled.
The conflicting information in the 10-Q and PV-10 needs to be resolved. Based on existing public information it is hard to know whether the mitigation plan is just to make sure the major reserve revision in the PV-10 does not get worse, or whether there can be some recovery from the initial estimate. This question was not directly asked at the earnings call. I am inclined to want some actual evidence of improvement before bidding up the shares based on the accounting entry. However, there is a probability the results won't be as bad going forward. I will provide information about how this can (and already has) affected share value in the fair value section of this article.
Production Mix Analysis
The PV-10 published in the most recent CHKR 10-K showed that the Trust over the past year showed a slight decline in oil in its production mix relative to natural gas and NGL. This product mix composition trend continued to be confirmed in the past quarter results:
The trend over time has had a small impact on the value of the Trust as BOE volume has trended to lower value products. However, the impact in the most recent quarter due to production mix was not a major contributing factor on earnings performance.
The biggest positive impact on the CHKR Trust earnings performance in the past quarter can be found in the market price for natural gas. 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 $31.74 in the November to February production quarter. This is 6.23% higher than the $29.76 the prior quarter. As the market prices reflect, the big downward change in the realized price level at the Trust occurred three quarters ago -- when both oil and NGL prices suffered significant declines.
Overall the improvement in realized price is primarily due to the increase in natural gas prices. The Trust oil production is estimated to be 100% hedged with derivative contracts that lock the realized price at $88 per barrel for oil. The NGL price is hedged using oil to the extent swap contracts cover production volume at a ratio of approximately 2 to 1. This only hedges general energy market price declines and does nothing for swings in the underlying NGL product market. As you can see from the graph, NGL market prices have been in the dumps since last summer and remained low during the past production quarter. The spread differential of 2.6:1 over the past several quarters has placed a strain on realized NGL prices when the impacts of the hedges are included.
The good news is that market data show that the spread is narrowing in the market presently and NGL prices are in the recent trade above $40 per MBOE (price does not reflect delivery differential for CHKR). I expect the trust will see a steady improvement above the $32.67 NGL realized price in the coming quarters. There is also long run promise for the NGL market prices if more delivery infrastructure is completed and exports markets can be accessed. The biggest risk I see currently for this path is political.
Trust Derivative Position Analysis
The Chesapeake Granite Wash Trust has most, if not all of its liquid production hedged presently through September 2015 -- which coincides very closely with the estimated time frame that subordination protection to common unit holders will end.
The bad news about the derivative position is that it is currently a negative drag on the Trust earnings potential as shown in the graph below. Based on the forward pricing curve the negative impact on Trust earnings through is $(9.8M), or $(0.209) per unit. However, the hedges do serve as a floor under which trust income from expected oil and NGL volume cannot fall below. With the hedges in place the Trust cannot realize higher (or lower) prices on oil and NGL production volume, with the exception of any basis risk from actual underlying product delivery, until Q4 2015. In the case of oil delivery, the basis risk for the Trust appears to be nominal at present and the hedge has been effective. However, the widened spread between NGL market delivery prices and oil prices has made the derivative contract total ineffective for hedging NGL downward price moves.
The Trust does not hedge natural gas prices, and the general price improvement trend in the market has flowed through to the Trust's earnings in recent quarters.
In the Trust's 10-K published in early March, the year end PV-10 was supplied which showed a per share value of $9.47 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 $9.26 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 $26.76 per BOE at the price assumptions shown and a production mix of Oil 12.7%/NGL 32.6%/NatGas 54.6%. This composite price is well below the current market average.
- If the natural gas price averages $4.12, the realized composite average price in the PV-10 improves by $30.83. The estimated adjusted PV-10 would be $10.84.
PV-10 Trust Comps
The current PV-10s of Trusts that I track (NYSE:PER) (NYSE:SDR) (NYSE:SDT) (NYSE:ECT) are shown in the table below, and as you can see, the Chesapeake Granite Wash Trust is trading at a price point that is 1.74x its adjusted PV-10 (1.85x using the May 14, 2013 market price). The CHKR production mix is generally higher on average in natural gas mix, and is trading in a range, which is comparable to the SandRidge Mississippian Trust II. 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.
Trust Fair Value Estimation
In my previous valuation of CHKR, 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 -22.9%, and was derived from a thorough analysis of the Dec. 31, 2012 PV-10. In this report, I have modified the model slightly to allow a more accurate fit of the going forward production to market expectations for energy prices, as well as to model the expected drop off in distributions that could occur post an early end to subordination.
The table below summarizes the information used in the model to derive a go forward distribution forecast when combined with the expected depletion of remaining proven reserves held by the Trust:
The model price assumptions are based on the forward price curve for oil and gas prices combined with the Trust hedge contracts through September 2015, and then post hedge use 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 reached in 2029 for oil, but are not reached before Trust termination for natural gas. 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 as shown in the table, which is a downward adjustment in oil mix from the IPO distribution model.
One additional variable was added to the production and distribution model for this article -- the impact of potentially better well performance on the remaining wells to be drilled than the previous estimate. There is no means of knowing this at this time; I have only included it for sensitivity analysis reasons in addition to the base case revision. The current model results shown below include the fair value estimates for both cases. Total proven reserves depleted over the remainder of the Trust in the production curve shown above equals 30,942 MBOE. The base case model, which I also review below, assumes the current PV-10 minus the latest production period equals 27,568 MBOE.
Based on these model assumption, at the current unit closing price level of $17.19 on May 14, 2013, the implied rate of return on the Trust if bought and held to termination is 5.7% in the base case PV-10 scenario, and 6.7% assuming the Trust's efforts to mitigate the loss in well performance in remaining to be drilled wells produces a 30% recovery of proven production reserves previously estimated to be lost, through time.
I choose the 30% recovery for a reason. It is the point at which I estimate the drilling operator, Chesapeake, will not be taking a loss in distributions below the subordination threshold on its subordination shares. There is every incentive for Chesapeake to at least spread out the drilling locations on the AMI in order to improve the return on its own account for the next several years. Beyond this point, however, I am skeptical.
(Note: the March 20 article at a 10% discount rate produced a $13.45 valuation using a 22.86% impact on proven reserves factor. The new model uses the same level of reserves as adjusted in the PV-10, but the underlying assumptions produce a 1.4% lower impact on distributions over time. The new model aligns with the market traded range of $14 per unit post the PV-10 reserve report publication in March.)
As the model shows, the fair value estimate at a 10% rate of return is $14.03 for the base case, and improves to almost $15 if the drilling mitigation plan shows reasonable success. The valuation is lower if a higher market return is used as the discount factor. This valuation will adjust downward after the ex-dividend date on May 17.
The Chesapeake Granite Wash Trust continues to show very poor results when compared to the plan sold to IPO shareholders. That is the ugly inconvenient truth. The good news in the quarter is that natural gas prices improved results, there is a possibility the drag on earnings from NGL price levels will be reduced in coming quarters, and there is a mitigation plan in place that will "hopefully" produce some positive impact on the performance of the remaining to be drilled wells.
All of this said, there is currently very little prospect for the Trust to recover to the point over the next several years in which it can actually exceed the subordination threshold level in distributions to common unit holders -- short of some spectacular upward move in natural gas and NGL prices and a major upward revision in proven reserves. All of these are unlikely events, in my opinion, in the intermediate term.
Based on this review combined with a 10% baseline floor rate of return, I suggest the fair value of the Trust should be in the range of $14-$15 or even below, not $17. On a relative basis, there are other Trusts in the market that are trading at higher discounted rate of returns, which I have evaluated using the same model and methodology. I see nothing to warrant a premium in the pricing of the Chesapeake Trust to the other Trusts at this time. That, however, is an opinion. I hope the facts provided in the report will help you make a better informed decision for your own investment portfolio.