I noticed BP Prudhoe Bay Fund (BPT) was in the news today, with an analyst from the risk management firm Hedgeye, detailing the reasons for its short position. Kevin Kaiser, the analyst behind the research dubbed the opportunity as a rare "asymmetric risk/reward opportunity", with a net asset value target of $33 per share. In the article below, I will examine the short position mentioned by the analyst and propose an alternative energy portfolio for the income seeking investor.
- "Short BP Prudhoe Bay Royalty Trust (BPT -2.8%) is a rare asymmetric risk/reward opportunity," says Hedgeye's Kevin Kasier, just wrapping a conference call detailing his arguments.
- His base case - which assumes the current WTI price strip, production declines of 2% per year (fell 4% in 2013), annual inflation of 1.5%, and weighted-average cost of capital of 9.7% - leads to a NAV of $33 per unit, more than 50% below the current price. The last distribution would occur in 2024, and the total undiscounted distributions would foot to just $46 per unit (current price is $75).
- Key to Kaiser's analysis is the automatic cost escalations - they're written into the trust conveyance ("written in stone") and adjusted by an inflation factor. At $16.80 per barrel today (not including the inflation adjustment), they really begin to ramp in 2018 ($20-2018, $23.75-2019, $26.50-2020) and won't leave much available for distributions after.
- Under what scenario might BPT be worth its current price? Production declines of just 2% per year, and the unlikely combination of zero inflation, and WTI crude rising to and staying at $120 barrel.
- "The ultimate retail yield chase product," says Kevin Kaiser of royalty trusts in general.
As we can see from the above bullet points, Kevin proposes two different scenarios based on the future price of oil and the overall annual inflation rate over a 10 year time span. In his bearish scenario, he proposes the price of oil will remain "within its current price strip" over a 10 year span, while the overall inflation rate will check in at a rather benign 1.5% rate. I personally don't see how this is possible. The inflation rate consistently comes in well over 1.5% over the past ten years as we can see from the chart below. I found a very interesting site with inflation data going back as far as 1914. By quickly sifting through the data, it becomes abundantly clear that an inflation rate below 2% is an anomaly that will most likely not be repeated over a ten year time span.
The price of oil is in my view, one of the key components of inflation as the costs to locate, extract, develop, refine and deliver to the end user become more expensive as the years go on. I am firmly in the camp that the price of oil will rise over the next ten years, as it becomes more expensive to produce oil and it's by products. I actually believe the $120 target for oil is quite achievable as it would imply a mere 2.92% CAGR, using $90 per barrel as a starting point.
Mr. Kaiser raises some very valid points pertaining to the automatic cost escalations that are written into the trust. Those numbers are indeed correct and will be a cost that must be deducted from future revenue. The trust is of a limited life span with 2024 as its expected date of termination. The trust has been experiencing a reduction in volume and will be prone to more downtime which will affect net total output. I would like to also point out, over a ten year time span the world will undoubtedly enter into a recession which will depress the price of crude oil. A decrease in the price of crude oil will cause the "dividend" received from the company to fall. Feel free to view historic quarterly payout info to illustrate this point.
An investor in BPT in my view, should view the "dividend" as a return of capital first and foremost. To illustrate this point, I will use BPT's net dividend payout for 2013 of $9.04 in my example. At a current price of roughly $75 per share, an investor would recoup all his initial capital after a little over 8 years. The stock is not suitable as a reinvestment play as it is a "wasting asset" so the laws of compounding don't apply here. After recouping the original investment, the remaining distributions, coupled with the liquidation of the trust would be the investors "true" dividend. How much would this be is beyond my best guess hence the reason for the liquidation of my stake as detailed here.
After interacting with quite a few commentators, it became very clear to me that quite a few people are relying on BPT to fund their retirement. Any sort of replacement would have to "reasonably" offer a similar yield. I fully realize that replacing a quoted double digit yield is impossible in this market environment; however yields approaching 5% do exist.
In this current environment, Royal Duct plc (RDS.B) offers a yield north of 5%, with a long history of steady yearly increases. Ray Merola does an excellent job covering RDS.B, and I suggest reading some of his past work to get a good feel for RDS.B. I am still quite a few years from retirement, so immediate income isn't my primary goal. I hold Exxon/Mobil (XOM) and BP (BP) as my exposure to the energy field. For those who are looking for a combination of capital gains along with an above average yield, BP in my view would be a better choice than RDS.B.
I would also like to draw income seekers to the attractive yield that is currently offered by AT&T (T). T is an American based communications firm with a long history of dividend payments coupled with yearly increases. The yield is now comfortably above 5% for this venerable Dow 30 member. For a more in depth overview of T please click the following link.
In conclusion, Hedgeye has certainly raised some valid points in regard to BPT. While I am not in agreement with all of the assumptions made in their bearish case, I don't find BPT to offer a compelling investment at this time. I feel there are too many unknown variables to accurately predict what the trust is really worth. I am more comfortable holding the oil majors as the primary source of the exposure to the energy field. I thank you for reading and I look forward to your comments.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.