Fixed income investors searching for yield in the U.S. Royalty Trust sector have been caught in a "buzz-saw" since the end of October 2013 through the latest year-end trading session. The chart below gives a good idea of the carnage across the sector, particularly in the fixed termination date Trusts operated by Chesapeake Energy (CHK) and SandRidge Energy (SD). The decline comes only 8 months after a similar steep decline that began in February of 2013. The retracement of losses after the February move was small, so the collapse that began at the end of October is a continuation of the severe bearish sentiment in the sector.
In November 2013, I published in-depth research articles on four trusts: SandRidge Mississippian Trust II (SDT), SandRidge Mississippian Trust I (SDR), SandRidge Permian Trust (PER) and Chesapeake Granite Wash Trust (CHKR). The unit price performance during the year for each Trust, relative to the Dow, is shown in the chart above. This article provides a perspective on the motivation behind the market decline and an assessment of the relative value of each Trust at the present time, given the much lower pricing of the units. You can access the detailed reports published in early November in my publication library, and reference links are listed at the end of this article. You can also link to the research reports on the Financial Calculus web-site.
What factors underlie the Sell-off?
The market price action in the oil and gas royalty trust sector since early November is best described as a capitulation sell-off. All four Trusts shown in the chart above traded higher leading up to the 3rd quarter distribution announcements made at the end of October. Then, almost on cue, a rapid gap down in unit prices followed. Individual investor motivation for selling is often hard to discern, but in the royalty trust market, the three factors that appear to be strongest at the present time are tax loss selling, fears of oil and gas over-supply in the U.S. market, and downward price adjustments due to poor drilling results.
Without question, these Trusts have been plagued by inferior drilling results and production. Each one is analyzed in my individual reports, and harsh downward adjustments on future production have been made during the year. The next PV-10 report, which will provide an update on the proven reserves, is not available until each Trust publishes a new 10-K, usually scheduled for release in March. Until that time, the best available information is actual performance and any information that can be gleaned from earnings reports. Having reviewed a majority of the public data, there is nothing in the latest reports that should have driven a 30-40% across the board sell-off in the unit values in my opinion, particularly against the backdrop of economic expansion expected in 2014.
The second factor that weighs on the market is the fear that somehow the increasing level of supply in the U.S. energy market is going to result in an implosion in the price for oil and gas. This expectation is understandable, and the research reports provided took into consideration the forward pricing curve for oil and gas markets which are the best indicators of future pricing direction. The forward curve for oil and gas presently does not show an imminent downturn in pricing. See (Henry Hub Natural Gas Futures) and (Light Sweet Crude Oil (WTI) Futures) for forward price curve information. In fact, market pricing is actually showing stability and upward movement, particularly in natural gas. The spot oil market briefly approached the low $90 level in November, but has since rebounded toward the $100 level. Additionally, the natural gas market forward price curve is above $4.00 per mcf and upward sloping through 2023. All of the Trusts except SandRidge Permian are heavily dependent upon the recovery of natural gas and natural gas liquid pricing. Both of these markets are showing strength presently, and should continue to do so if the U.S. economy begins to expand.
If there is one aspect of the forward curve that may fundamentally be driving the unit pricing of these Trusts down, it would be the oil market forward curve. Presently, WTI Light Sweet crude oil pricing in the 2017 and beyond time window is below $80 per barrel. The price level is indicative of the market oversupply expectations driven by shale oil exploration and production, particularly in the Bakken. The view that crude oil will create oil over-supply in the U.S. was voiced in a December 12 article in the Wall Street Journal about Exxon (XOM) (Exxon Calls for Crude Oil Exports).
A couple of market observations may be useful for investors trying to understand the dynamics in the market presently. The Exxon call for energy exports was particularly targeted at light sweet crude which is increasing in supply from the shale plays. U.S. refinery capacity, however, is best geared to heavier crude oil, and it is unlikely that new refineries are going to be built at the present time. Sandridge Permian, which is the most oil concentrated Trust, is more geared to the refinery demand. Exxon also states strongly in the article their belief that worldwide demand for crude oil will continue to expand. Whether the Exxon call for allowing oil exports will be heeded by the Obama administration is unknown; however, I do not expect that the Bakken fields will be highly profitable at $70 per barrel.
In fact, the North American supply might well shrink at these price levels. My expectation is that Saudi Arabia will continue to control the pricing of crude oil on the margin, and as long as U.S. money supply continues to grow, the market price for crude oil will track through time steadily above $100. The only scenario in which this does not happen is a deflation-led market decline, in which case, investors should be more worried about their stock market index correlated positions (SPY) (DIA) (QQQ), not their fixed income trust shares, which already appear to have the collapse priced in.
The last factor, and possibly the most rational reason that the unit price of the Trusts declined so precipitously since late October, is simply that there are too many investors who want to sell. My blog posts have repeatedly pointed out that a fixed termination date Trust is not a security that an investor should enter with the expectation of price appreciation. It is a security that through time will asymptotically decline to zero over the life of the Trust. In the case of these four Trusts, the termination dates are in the 2031 and 2032 time frame reflecting the 20 year term of the Trust from IPO. But the severity in the pricing break-down of the shares leads to an interesting tax situation for many of the investors who may have entered the shares at the IPO. The IPO price levels for each of the Trusts ranged from $19 to $21. In certain cases, post IPO, the traded unit prices actually increased into the mid $20 range. In other words, brokerage statements at the end of the 3rd quarter reflected a very large tax loss for many unit holders who may have intended to stay invested, but the present value of the large loss booked against possible very high gains in other sectors of the stock market may have been too compelling financially to turn down.
Any year-end tax motive selling should dissipate in the coming week. Given the largely oversold market, January may now become the month in which many of the high flying, low growth stocks are sold by prudent investors at capital gains, and these Trusts may become compelling investments to park funds to earn an above average return at a reasonable price.
PV-10 Relative Trust Comparison
In order to provide a relative perspective on the impact the unit price level declines have had on each Trust, in this article section, a comparison of the current traded market price of each Trust is compared to its 2012 year end PV-10 value per unit, adjusted for current year production.
The PV-10 report of each Trust is the estimated future oil and gas revenues, net of estimated direct expenses, discounted at an annual discount rate of 10%. Each Trust publishes a PV-10 report in their 10-K during March of every year. For each of the Trusts you can access their current 10-K by using the following links. SDR 10-K, PER 10-K, CHKR 10-K, SDT 10-K
The PV-10 estimate is a consistent means of measuring the value of remaining oil and gas reserves held by a company in the industry. The PV-10 calculation uses constant price level assumptions for the life of the proven reserves, as shown in the table below. In the end of year 2012 PV-10s, each Trust utilized the following oil and gas price levels, which are net of delivery costs, in order to estimate the value of their remaining proven reserves.
The natural gas price level is highlighted in red in the table, because the price level in 2012 was severely impacted by the oversupply. The market price for natural gas has since stabilized, and a futures contract for March 2014 delivery is currently trading at $4.45 per MMBtu (as of 12/26/13). This price does not reflect Trust specific delivery costs which can range up to 30% of the market price level as in the case of CHKR. Each of these costs can be found in the Trust 10-K. When the Trust PV-10s are updated at year-end, the price levels of natural gas used to estimate the value of proven reserves are expected to be significantly higher.
The oil price level assumed in the 2012 10-K is very reflective of the 2013 pricing environment for oil, and I do not expect a significant change in upcoming reports.
The primary risk for all of the Trusts at the present time is further adjustments to proven reserves due to well performance. I have discovered that the long tail production results from fracked wells is still a bit of an unknown. This phenomenon is the gotcha that investors need to be wary of presently in all oil and gas investments, as it may turn a value play investment into a value trap.
When the PV-10s of all the Trusts are compared against the current traded unit price level, a significant discount can be seen in the relative values. The table below provides the PV-10 summary.
Currently all of the Trusts are trading at a unit price level, which is either discounted to the 2012 adjusted PV-10, or within about 10% of the value. The SDT and CHKR Trusts are showing a slight premium, most likely due to the returning strength in the natural gas market and the depressed gas price level used in the prior PV-10. On the other hand, the more liquid heavy trusts, particularly PER, are trading at a discount to their adjusted PV-10. The higher dependence on oil prices for future value is likely a factor in the market discount of these shares.
Valuation Comparison Based on Estimated Future Distributed Earnings
Because the PV-10 uses a static oil and gas price level to value reserves, a valuation model to reflect other factors that may impact unit value is needed. Potential factors other than future energy prices include the value of derivative contracts held by each trust and the near-term safety net for distributions afforded common unit holders by the drilling operator subordination of units. In the Trust research reports I published in November, each of the above Trusts were valued using similar assumptions with respect to the forward pricing curve for oil and gas, as well as adjustments incorporated to reflect the derivative contracts they possess - favorable in the case of all the SandRidge Trusts, not favorable in the case of the Chesapeake Trust. The earnings for each Trust was derived by estimating production using a production curve which best reflects current well performance through the end of life of each Trust.
The result of this analysis process provides a slightly higher reflection of the fair value of each Trust than the current adjusted PV-10 in the case of every Trust. The valuation of each Trust can be found in the Valuation at 10% Discount Factor column in the table below. Please reference the initial report for supporting details for each valuation.
The net result of this analysis is that each Trust is currently trading at a significant discount to an earnings model valuation based on the remaining payments expected to be made to unit holders through the Trust termination. The CHKR trust is trading closest to the model fair value, while each of the SandRidge Trusts are 20% to almost 30% undervalued, assuming 10% is a fair rate of return.
Beauty is always in the eye of the beholder, and in the case of U.S. Oil and Gas Royalty Trusts, many investors have been burned by initial IPO price levels that were significantly inflated, resulting in a price collapse in the 4th quarter of 2013, as many initial investors sell and take the tax write-off. Whether these units will recover to more appropriate risk adjusted fair values given the history, I cannot predict. However, on a fundamental basis, the current market price levels across the board appear attractive for long-term fixed income investors seeking higher returns. One advantage of this type of investment is low duration, which continues to be a good characteristic to have in an investment portfolio, as interest rates, particularly in the 5 to 10 year maturity range, are expected to rise more quickly in the coming year if economic growth pushes higher. Each Trust has a slightly different level of expected near term pay-outs, but on average over the next 2 years, the Trusts will pay out from $3 to $4 in distributions, significantly reducing the risk of entering the investment at $9.00 to $11.50 depending on the Trust.
Overall, I continue to add to ownership levels in the energy sector, as I have been throughout this year. These Trust represent true dogs of the investment universe in 2013, just as Exxon is in the Dow - dogs which may be darlings in the coming year if economic growth picks up, or at the very least, provide necessary protection from the unknown impacts of over $2.4T in excess reserves resting on U.S. Bank balance sheets parked at the Federal Reserve due to the massive quantitative easing program.
Disclaimer: All opinions and analyses shared in this article are expressly the author's, and are intended for information purposes only and not advice to buy or sell.