A Tiny Oil & Gas Trust With A Huge Margin Of Safety And A Catalyst

| About: LL&E Royalty (LRTR)

This article is for information purposes only and is not meant as advice in any way or form. Do your own due diligence before you invest.

This article describes a micro cap stock with a stock price around $1 and a market cap around $20 million. Please be aware that investing in micro caps can have many risks, as described at the bottom of this article.

Summary

This investment idea is a special situation based on:

  1. A recent valuation of LRTR's (OTC:LRTR) net profit interest in the Jay field in Florida. This is just one asset of LRTR, but valued substantially above LRTR's market cap;
  2. Change of the trust agreement to allow the trustee to sell part of the trust's assets instead of selling all the assets at once and only after formally terminating the trust;
  3. Change of the trust agreement to allow the trustee to sell part of the trust's assets not just for cash, but also marketable securities.

Introduction

On June 28, 1983, The Louisiana Land and Exploration Company (company) created LL&E Royalty Trust (OTC:LRTR).

Upon creation of the trust, the company conveyed to the trust, net overriding royalty interests (overriding royalties), which are equivalent to net profits interests of 50% in certain productive oil and gas properties located in:

  1. South Pass 89
  2. Jay field, Florida and Alabama

and 90% in the following productive oil and gas properties in:

3. Federal waters offshore Louisiana

- East Cameron 336

- East Cameron 195

- South Marsh Island 76

- Eugene Island 261

- Vermillion 331

Net revenues attributable to the trust for the years ended December 31, 2007 and 2006 as described above, were approximately $1,600,000 and $2,100,000. Consequently, as stated in the trust agreement, the trust was required to terminate and was required to sell the assets of the trust for cash by means of a public auction.

Thanks to a lawsuit by a major shareholder (Jeffrey R. Beckett with 22% of the trust units) this mandatory termination was delayed and the trustee was replaced by a new trustee that was willing to continue to wait until the assets of the trust could be liquidated against the actual value.

Jay field, Florida and Alabama

The Jay field is comprised of approximately 14,400 contiguous acres located on the Florida-Alabama state line. Since its discovery in 1970, the field has produced approximately 467 MMBoe. Production from the Jay field is primarily from the Smackover carbonate formation at an average depth of approximately 15,000 feet.

Quantum Resources Management purchased numerous interests in the Jay field in 2006:

  1. On December 22, 2006 Quantum Resources Management acquired ExxonMobil's interest in the Jay field for $142 million.
  2. On December 21, 2006, Quantum Resources Management purchased certain interests from ConocoPhillips for $130 million. Of that purchase price, $67 million was attributable to the Jay field (13-D filing Robotti).

Recent valuation of LRTR's net profit interest in the Jay field in Florida

In January this year, Quantum Energy (a limited partnership where Quantum Resources Management is the managing partner) bought the Jay assets from Quantum Resources Management for $145 million. (see Quantum Energy press release of January 2013).

This gives us a valuation to compute the value of the trust's 50% net profit interest in the Jay field.

To do this we need to establish what the interest of Quantum Energy was in the Jay field at the time of the transaction.

Quantum Resources Management bought in total a 92% working interest in the Jay field from Exxon and ConocoPhilips in 2006. (13-D filing Robotti).

Of that 92% working interest ConocoPhilips had a 37% working interest. This 37% working interest was entitled to a 30% net revenue interest. The difference (19%) is because of the mineral royalty that needs to be paid to the land owner(s) as well as taxes.

This 30% revenue interest was burdened with a 50% net profit interest of the trust. A net profit interest is a right to receive a profits attached to certain revenue after deduction of certain cost.

As this is somewhat complicated, I have put it in a little scheme below:

working interest 93.5%
mineral royalty 19%
net revenue interest 75.4%
Click to enlarge

This leads to the following distribution between Quantum Resources Management and the trust:

Quantum trust
Net revenue interest 75.4%
Net profit interest 60.4% 15%
Click to enlarge

In December 2010 Quantum Energy LP went public and the managing partners did this by transferring some of the assets of their sponsor (Quantum Resources Fund) to the LP. Amongst these was a 7.4% overriding oil royalty in the Jay field (which is equal to a net revenue interest and in this case also to a net profit interest as this interest was not burdened by the 50% net profit interest of the trust or any other net profit interest for that matter) (see Quantum Energy press release of January 2013).

Total net profit interest of Quantum Resources Management was 60.4%. Quantum Resources Management transferred 7.4% of this to Quantum Energy when they went public, leaving them with 53%.

So we can conclude that when Quantum Energy bought the Jay assets for $145 million, they actually bought a 53% net profit interest.

The trust's 15% net profit interest is thus valued at ($145/53)*15 = $41 million.

The trust's current market cap is $20 million.

Change to the trust agreement

On May 31 a special meeting took place to vote over a few changes of the trust agreement. All changes were accepted at the meeting. (See the DEFR 14 filing.)

One of these changes, in my opinion, is set up to make a sell of (a part of) the trust's assets easier:

  1. The trustee does not have to terminate the entire trust to sell assets. He can now sell individual assets also if he has a plan to terminate the trust. (So the trustee can sell the net profit interests in the Jay field without having to terminate the entire trust…)
  2. The trustee may now also accept marketable securities as payment for a sell instead of cash only (these marketable securities could very well be those of Quantum Energy LP…)

The Margin of Safety

The margin of safety is huge as the minimal proceeds of a sell of the Jay assets should be $41 million - $3,3 million (see downside below) against a current market cap of $20 million.

Upside

The upside is that the Jay field is just one of the assets of the trust (although the most valuable). The other assets are

  1. South Pass 89
  2. Offshore Louisiana

The latest Q10 (09/30/11) shows the income these assets would have generated if this income would be free to be distributed. Unfortunately this isn't the case as the working interest owners have decided to make use of a provision in the agreement between the trust and the working interest owner to escrow all income otherwise distributable to the trust. The escrow is meant for future abandonment cost as well as historic capital expenses and operating cost that could not be covered by the income distributable to the trust at that time.

Unfortunately the South Pass 89 and a lot of the Offshore Louisiana assets were heavily damaged by hurricanes Katrina and Rita and the repairs needed substantial capital expenditures. The capital expenditures attributable to the trust were paid by the working interest owners at the time (as the trust did not have the necessary funds available) and any income otherwise distributed to LRTR was withheld in escrow.

Luckily though, based on my own rough calculations, the maximum amounts allowed to be escrowed will be reached in the foreseeable future, allowing the trust to distribute the income beyond this point as a dividend.

To see what this income would be, we need to dive into the latest SEC filing, which is Q3, 2011. The income of these assets is equal to the amounts that were escrowed as the other costs (capital expenditures as well as operating expenditures) are standard.

In Q3, 2011, the income otherwise distributable was:

South Pass $ 417,427
Offshore Louisiana $ 749,894
Total $1,167,321
Click to enlarge

Don't ask me what the assets are worth based on these numbers, as I don't know. But at least several millions (better to be roughly right than precisely wrong…).

Downside

In the same SEC filing we can see the amounts the trust is owed to the previous trustee (as they were financed by the trustee due to lack of funds in the trust):

  1. The total amount advanced to the trust of $2,582,294
  2. Unpaid invoices for administrative services totaling $619,153
  3. Also Beckett, as part of the trust agreement change wants the cost of his lawsuit reimbursed. My (wild) guess is that this will be around $100,000

So we need to deduct at least around $3,300,000 of cost from the proceeds of the sale of the 15% net profit interest in the Jay field before the unit holders can be paid.

Conclusion

LRTR is substantially undervalued based on one of its assets only (Jay field). It has a lot of upside based on its other assets and given the current changes in the trust agreement a sell in the short term seems very likely. Quantum Energy LP seems to be the most likely candidate.

Disclosure: long LRTR (both personal portfolio as the funds I manage)

Risks

This article describes a micro cap stock with a stock price around $1 and a market cap around $20 million. Please be aware that investing in micro caps can have many risks, amongst them:

  • limited liquidity. This can prohibit a swift entry and or swift exit from an investment at the preferred time and/or price;
  • price sensibility. Due to limited liquidity any entry/exit from an investment can have a substantial influence on the price of the investment;
  • limited information. Due to the character of a micro cap they can be subject to exempt compliance rules, which may cause that not all and/or only selected information is publicly known to investors and that facts/objective data can be difficult to distinguish from rumors/personal statements.

In addition to the above risks there are specific risks with investing in LRTR, amongst them:

  • more than 50% of the outstanding units are held by only 4 individuals. So effectively they control LRTR;
  • the newly appointed trustee is also the CFO of a private company controlled by one of the major holders. In addition to that, he has no previous experience acting as a trustee;
  • LRTR does not operate any assets itself. It is dependent on the operator of the assets to make the (right) decisions;
  • the operator of the assets can legally withhold any funds that would otherwise be distributed to the shareholders of LRTR (for future abandonment cost and excess production cost) and has done so for the last 5 years;
  • the operator of the assets (as a potential buyer of LRTR's net profit interests in the Jay field) has opposite interests as to those of the trust and can frustrate any transactions and/or payment of dividends to unit holders;
  • LRTR is not current on its reporting, so there is no assurance to what the exact numbers are on current production and reserves

Disclosure: I am long OTC:LRTR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.