The latest reported quarterly results by SandRidge Mississippian Trust I (NYSE:SDT) showed a continuation of deteriorating production volume and poor earnings performance. On October 24th SDT announced its quarterly distribution for production during the time period of June through August 2013. During the summer the energy market showed relatively high oil prices throughout, but weaker natural gas as oversupply in the market continued. NGL prices improved, but the spread relative to the price of crude oil remained wide.
Upon the announcement of earnings and the quarterly distribution, the stock responded swiftly and negatively, gapping down from over $14 per unit to its present trading range around $12.50.
In the context of a generally healthy energy market, SDT's common unit distribution of $0.60 was 21.3% below target. Overall earnings on a fully dilutive basis, for the 3rd quarter in a row, could not cover the subordination threshold for the Trust, leaving the common units with a lower than threshold distribution. The more alarming aspect of the latest earning release was that the subordinated unitholders received no distribution at all.
As the above graph shows, SDT's distribution levels have stabilized since the May distribution of this year. However, the leveling off masks the Trust's underlying earnings problem because the common unitholders are protected by a subordination threshold. The inability of the Trust to even reach the subordination threshold for the common distribution is a troubling sign.
The Trust press release references lower realized natural gas price levels and lower oil production as the cause for the miss. This statement is made relative to the Trust IPO prospectus which projected a higher overall MBOE volume in crude oil than was eventually discovered, as well as higher natural gas prices than are currently being realized in the market.
Given my previous reports that have tracked SDT's performance (see SandRidge Mississippian Trust I - Dramatic Decrease in Well Performance Shown in Reserve Report, SandRidge Mississippian Trust I - Poor Quarter Results Show Elevated Risk and SandRidge Mississippian Trust I - Small Improvement, Under Performance Continues), the below target distribution level is not a surprise; however, its below threshold level performance is a new low. SDT appears to be on a course for constant (20%) + below target results near term, and even worse intermediate term performance relative to its IPO distribution target levels as the subordination period expires in 2014. This report provides an update of the trends and data which point to this conclusion.
SDT Earnings Performance Analysis
In the press release announcing the Trust results, management pointed to "lower oil sales volume" than the estimate in the IPO prospectus as the reason that the distribution target was missed. The PV-10 released earlier this year in the Trust 10-K showed a sharp decrease in MBOE proven reserves of -17.9% during 2012 due to well performance. The degradation resulted in a shift in product mix forecasted from 43% oil, to an oil / NGL mix of 23.3% / 15%. The adjustment indicated a 4.7% reduction in liquid product production overall.
During the last quarter, production volume was 296 MBOE, much lower than production in the March-May quarter (the current quarter distribution reflects June-August production). The production level was down 28.7% compared to the same production quarter in 2012. The drop in production can be linked to the completion of the drilling obligation to the Trust by the operating general partner SandRidge. A large number of the wells drilled appear to have resulted in initial high pressure output, which subsequently declined rapidly resulting in poor oil output.
The degradation in earnings performance is most directly linked to the decreasing percentage of liquids (crude, NGL) in production.
Drilling was completed by SandRidge in the previous quarter. The work was completed at an accelerated pace, well ahead of the schedule set at the IPO.
Based on the date that drilling was completed, the subordination period will end beginning with the August distribution in 2014. Investors need to be aware of this date, particularly since the Trust is not earning enough currently to fully cover the subordination threshold. If earnings do not improve over the next year, and it is highly unlikely that they will, common unitholders will see a drop in distribution level this time next year below the current 80% of target threshold afforded by the subordinated unitholders. At the present time, the projection model I have developed shows distributions dropping to at least $.50 per unit in August of 2014, and possibly even lower depending on market price levels and the on-going well performance.
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 above the natural gas and oil percentage mix over the last year is plotted to see if the trend line is actually reflecting a shift to natural gas. The trend line is not a positive sign for investors. The gas production volume has consistently shown greater levels of gas volume than reflected in the PV-10 (38 / 62). The result in the last quarter was (34 / 66), which was back to levels experienced in earlier quarters of 2013. The lower oil mix appears to be the performance level that investors need to expect going forward. The valuation model at the end of this report reflects the less valuable product mix.
Market & Realized Trust Pricing Trends
In the graph below you can see the actual market prices for oil, gas and NGL during the past year and the last SDT production period. Pricing in the overall market was strong for oil production; however, the price of natural gas was only slightly higher than levels experienced in the summer of last year. When the futures price curve for natural gas is reviewed, the current expectations are for a continuation of below $4 natural gas through the next several years.
The weighted average realized price at the Trust was $45.55 per BOE in the June to August production quarter. This is a (7.0%) decrease over the $48.96 per BOE realized in the prior quarter.
The shift in mix to more gas production volume is the primary contributor to the decline quarter over quarter. Realized gas price did not change substantially, $3.55 / mcf to $3.54 / mcf.
The realized price from oil products was a negative contributor to the average price level per BOE. In the latest quarter realized oil prices declined from $93.78 to $91.79. All of the crude oil production was hedged in the previous quarter at a futures price of $102.07. This means that the large differential was caused by delivery basis risk. The most likely culprit was the continued high spread between oil and NGL market prices.
Effect of Trust Derivative Contracts
The Trust has oil hedges in place for substantially all of its oil production at $101-$102 through December of 2015. It also carries hedges on approximately 20% of its natural gas volume.
The realized price levels for the latest quarter (oil $91.79, gas $3.54) contain the benefit from the hedges, adjusted for 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 spread between the two products in the latest quarter was not substantial and should not have affected the realized price above normal expectations. However, the $91.79 realized price level is an outlier in the recent performance given the hedges in place. The differential must be due to the spread between the delivery price of NGL products and the futures contract price of crude oil in which it is hedged.
The natural gas collar contract was supportive to the realized gas price during the latest quarter, 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 Trust has no hedge contracts in place beyond December 2015. Presently the forward price curve for oil in the 1st production quarter of 2016 shows an average price per barrel of $84.94, and $3.90 per mcf of natural gas. 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 natural gas prices will rise 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 2013, the 2012 year end PV-10 was supplied which showed a per share value of $8.36. This value reflects the expected cash flows from the remaining proven reserves held by the Trust, discounted at 10%. The PV-10 calculation uses constant price level assumptions for the life of the proven reserves as shown in the table below.
The table above updates the PV-10 estimated value for the depleted production volume at the Trust since the PV-10 report was completed. The adjusted PV-10 is $7.61 per unit share.
If the PV-10 per share is estimated using a natural gas price of $4.12, the current adjusted reserve valuation would be $9.09 per unit.
Trust Fair Value Estimation
The PV-10 is a static price level valuation model of proven reserves. To incorporate the value of potential changes in price levels going forward, as well as the value of the derivative contracts and the subordination threshold protection for common unitholders, it is necessary to use a discounted cash flow valuation model. The information contained below in this article is based on the valuation model I utilize to evaluate the fair market value of SDT.
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 product price level assumptions in the model use the current forward price curve for oil and gas combined with the Trust hedge contracts in place thru the end of 2015. The out year price levels beyond the 1st quarter of 2016 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 uses a product mix of 34.5% oil and 65.5% gas - adjusted downward to reflect the on-going lower well performance of the Trust.
When the price and mix assumptions are combined with the current proven reserves remaining at the Trust and the expected production curve, the distributions a unitholder can expect through the end of life of the Trust can be forecasted as shown in the graph below.
Through August of 2013, the Trust showed depletion of 23.2% of its proven reserves. Total remaining proven reserves are estimated at 12,984 MBOE as of the start of the September production period.
Based on this model, at the current traded unit price level of $12.64 on 11/04/2013 the implied rate of return on the Trust if bought and held to termination is 8.50%.
If you expect a 10% return, a fair price level for an SDT common unit is $11.70.
Because of the elevated risk being exhibited by the Trust due to well performance, my fair market estimate at this time is $11.00 per unit.
In my previous report, SDT was valued at $13.00 per unit. The lower target in this report reflects a reduction based on the distribution paid at the end of August, and an adjustment in the product mix to a higher concentration of natural gas which is more in line with on-going performance.
Daniel Moore is the author of the recently published book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only.