VOC Energy Trust (VOC) is an oil and gas trust that "owns a net term interest… to receive 80% of the net proceeds from… from oil and natural gas properties in the states of Kansas and Texas." (Source: VOC Prospectus, p1.)
The analysis presented below uses an engineering-style model to forecast VOC's future distributions based on individualized forecasts of production, prices, and expenses. While VOC's robust production suggests that investors are likely to see a steady income stream for the duration of the trust, the analysis shows that the current market price is unattractive; investors are likely to earn a small return on their investment, but could do better with other trusts discussed below.
A General Model Used to Value Trusts
An oil and gas trust is a type of commodity investment in which investors receive periodic royalty payments from the sale of oil and gas from a set of underlying properties. For investors, the value of a trust is the net present value, or NPV, of its future royalty payments. Although each trust has a unique process for determining its distribution, most resemble the generalized model shown below; the total distribution for a period is the gross revenues from the sale of oil and gas, less production-related expenses incurred by the proprietor, times the share of income owned by the trust, less the trust's own administrative expenses.
Of course, the devil is in its details. Future distributions are subject to uncertainties in well production, sales prices, and expenses, as well as unforeseen events. In addition, well proprietors and trust administrators may use various accounting and contractual techniques to manipulate net income and, indirectly, their distributions (see "Tricks that Inflate the Value of Oil and Gas Trusts"). While these techniques are legal and often spelled out in a trust's SEC filings, they can mislead investors. I recommend that all trust investors become very familiar with these techniques.
The rest of this article discusses the model assumptions regarding forecast revenues, expenses, and other underlying circumstances for VOC.
VOC: Key Model Assumptions and Considerations
Well production will rise briefly and then decline gradually through 2030
VOC's total oil and gas production has been increasing by 0.6% and 5.72%/year, respectively, since the trust's inception. The increases are noteworthy because most trusts that I have reviewed exhibit declining production. In the case of VOC, the increases are the result of ongoing well development by the proprietor, VOC Brazos, and total production will likely decline once well development slows or stops.
VOC Brazos provides only limited guidance regarding future development plans, so there is significant uncertainty regarding the timing of when total well production will begin to decline. For the analyses presented here, the model's middle case (calculated using a 3-period moving average) assumes that production will continue rise for 6 more quarters and then decline at a rate of 2.5%/year thereafter. The best and worst case production bands, shown below, are +/-3 standard deviations from the middle case.
As it turns out, the assumption regarding the duration of increasing production does not change the model results significantly. VOC Brazos passes through 80% of the well development costs to the trust, so the benefits of future production increases to unit holders are largely offset by their costs, which are discussed below.
Production will be sold at a discount to WTI and HH futures
Over the past year, VOC's production has been sold at prices that have averaged $2.56/bbl less than the WTI closing end-of-month spot price and $0.51/mcf more than the comparable HH spot price.
The model assumes that future prices will follow one of three cases. The middle case is NYMEX WTI/Light Sweet Crude futures and Henry Hub futures for oil and gas, respectively, adjusted for the historical spreads. The best and worst cases start with the NYMEX futures, but gradually deviate to values that are 15% greater/less. The various price curves used by the model are shown in the following chart.
Trust income from oil hedges will expire in 2014 Q3
VOC's total income currently includes revenues and costs related to the settlement of various oil price hedges. The remaining hedges, set at $102/bbl, will continue to contribute meaningful income until the last expires in June 2014 (reported in Q3).
Expenses other than development costs will hold steady over time
VOC Brazos deducts four categorical expenses from production revenues:
- Lease/operating costs average $3.5M/qtr and are assumed to be a function of time and the number of producing wells/acres. The model assumes that these costs will hold steady over time.
- Production costs and taxes alternate between peak and base values, averaging $2.2M and $0.6M, respectively. The model assumes that these costs are a function of total production volume and sales prices.
- Development costs average $3.2M/qtr and refer to new wells and workovers. The model assumes that these costs will continue for 4 quarters and then decline to $0.5M/qtr thereafter. Note that production is assumed to increase for 6 quarters to account for the lag between production and trust distribution.
- VOC Brazos has taken a $1M line of credit taken from trust reserves to pay for future development. The model assumes that no further credit will be issued and that the trust receives the balance upon its termination.
VOC trust management deducts a single charge related to trust management expenses that varies from a high of $409k (Q2 2012) to a low of $27k (Q4 2012), averages $227k, and exhibits no discernible trend to increase or decrease over time. The model assumes that this charge will continue as the historical average until the trust terminates.
The chart below shows total historical and forecast revenues and expenses attributable to the trust for the middle case.
VOC will terminate on December 31, 2030 and shareholders will not receive a payment for residual value
As cited in the trust prospectus:
The Net Profits Interest will terminate on the later to occur of (1) December 31, 2030, or (2) the time from and after January 1, 2011 when 10.6 MMBoe (which is the equivalent of 8.5 MMBoe in respect of the Net Profits Interest) have been produced from the Underlying Properties and sold. (p1)
[VOC Brazos]'s interest in the Underlying Properties will entitle it to 20% of the net proceeds from the sale of production of oil and natural gas attributable to the Underlying Properties during the term of the trust, and 100% thereafter (p4)
I'm not a lawyer, but that seems pretty clear to me. In 2.5 years, VOC has already produced 2.5 mmboe; production would need to crater for the trust to exist after Dec. 31, 2031.
VOC has an expected 5.5% ROI at current market prices
As based on the assumptions discussed above, future distributions for VOC are calculated for each of the three cases; the best case assumes high production volume and sales prices, medium, average volume and prices, and worst, low volume and prices. The table below shows the NPV for each case and for various rates of return, as of 1/22/14.
The current market price for VOC is $15.90 (as I write this). As suggested by the table, this price reflects roughly a 5.4% return on investment, or ROI, for the middle case, or an 11% ROI on the best case.
Although a 5.4% return is non-trivial, in my opinion, it is not high enough to justify the risks associated with VOC. For example, under the worst case, VOC's total remaining distributions will not cover the purchase price and investors will lose money. For me, a fair valuation would assume the middle case and an 8-10% ROI, which equates to $12.22 - $13.64/share, or 14-23% less than the current market price.
VOC distributions may rise, but then decline gradually through 2031
The following chart shows VOC's forecast distributions and fair value over time.
Investors should expect VOC's distributions to hold steady or increase through 2015 and then decline gradually to 2031. VOC's fair value should also decline steadily over time. While the model does not attempt to predict VOC's market price, the most significant events that could impact the market price in the next two years are 1) the loss of oil hedge revenue in 2014, 2) an indication by VOC Brazos of future well development plans, and 3) changes in oil and gas market prices.
VOC's value is average to low as compared to other trusts
VOC is the eighth trust that has been evaluated by the model. Others include:
- Enduro Royalty Trust (NDRO)
- ECA Marcellus Trust I (ECT)
- Hugoton Royalty Trust (HGT)
- Pacific Coast Oil Trust (ROYT)
- SandRidge Mississippian Trust I (SDT)
- SandRidge Permian Trust (PER)
- MV Oil Trust (MVO)
The table below shows a ranking of trusts based on the current ROI considering the model results, current oil and gas price futures, and the current market price. VOC ranks fifth.
Comparable oily trusts that investors may wish to consider are ROYT (12/5/13 forecast) and PER (12/17/13 forecast). Given the recent upswing in trust market prices, I am choosing to hold current positions but will not acquire any additional units.