SandRidge Mississippian Trust II (SDR) is an oil and gas trust that receives proceeds from wells operated by SandRidge Energy, Inc. (SD) in the Mississippian formation of northern Oklahoma and southern Kansas. SDR recently announced its Dec-2013 distribution at $0.568/share and its shares have recently traded at $10/share, with a robust trailing yield of 22.7%.
However, SDR is an investment value trap. The high trailing yield hides significant flaws, including declining production, an upcoming share dilution, and expiring revenue sources. I estimate that SDR's current market price, which is off nearly 30% from 2013 highs, is still nearly double the trust's NPV-10. That's not to say that there aren't possible plays, but I suggest that investors avoid long positions until 2014, or until SDR's fundamentals change.
SDR's future distributions will be significantly lower than past distributions
As those familiar with my articles know, I analyze trusts using a bottom-up engineering-style model that considers forecasts of future production, sales prices, and expenses, as well as the unique circumstances underlying the trust. In the case of SDR, these assumptions include:
- Future well production is fit to a power curve applied to historical production
- Future sales prices are based on NYMEX futures markets adjusted for the historical spread
- Future expenses are proportional to sales volume, total price, and time, as appropriate for the type of cost
- SDR's ongoing well development program will finish during Jun-14, with subordinated shares converting on June 30, 2015
- Revenue from hedges will end during the Dec-2014 quarter
- SDR will terminate in 2031 and pay a residual, which is estimated as a multiple of prior year production
I explicitly avoid consideration of published reserves.
Using the model, I estimate that SDR's NPV-10 is $5.35, which is 43% less than the current market price ($9.29 as I write this). These results suggest that the market is significantly overvaluing SDR, even when compared to most of the other trusts that I have reviewed. To understand why, we need to look deeper into the numbers.
SDR's wells are severely underperforming
SDR's underlying production has been a disappointment. The chart below shows total quarterly gas and oil production (orange and blue lines), compared with the number of producing wells (grey lines). As part of its obligation to the trust, SandRidge has added more than 170 producing wells in the last two years. While production initially increased with the new wells, natural well declines are wiping out any benefits that new wells bring. After SDR's well development program ceases, likely around June 2014, production declines will accelerate.
Source: created by author from SDR SEC filings and the author's analysis
Before moving on, it is also worth noting that SandRidge has added wells at a faster pace than anticipated. Per its agreement with the trust, SandRidge must add 206 wells by the end of 2016; the dotted grey line exemplifies a constant rate that would meet this obligation. However, SandRidge is on track to finish by June 2014, two and a half years early. While the early well completion raises production as compared to a slower pace, it reduces future production and expedites the conversion of subordinated shares.
SDR's price spread has been widening
SDR's sales prices have also been disappointing. In the past year, the average spread between WTI prices and those received by SandRidge has increased from $6/bbl to nearly $12. Not only is SandRidge getting comparatively less for their production, they are getting less during the trust's peak production years.
Source: created by author from SDR SEC filings and published NYMEX futures (2/11/12) and EIA data for WTI and HH sales
SDR's distribution is on the floor (and heading to the basement)
Given the production and spread issues, SDR's distribution has suffered. The chart below shows the historical distribution compared with the target distribution and the subordination and incentive thresholds. Of the past 5 distributions, not one has met or exceeded the target. The trust's revenues have been so low that the past two have hit the "subordination threshold," which acts like a floor on the distribution. But this threshold only helps so much; given the rate that SandRidge is developing wells, the subordinated shares will convert and the threshold disappear on June 30, 2015. Worse, given the declines in well production and prices (as well as an end to hedge revenues), SDR may not even have enough to cover the subordination threshold in the intervening months.
Source: created by author from SDR SEC filings and the author's analysis
So how overvalued is SDR's market price? As part of my evaluation, I tested against production and price sensitivity. Here are a few key results from these tests:
- Given the base forecast, SDR's remaining lifetime distribution is $8.25. There is a significant likelihood that investors will not recover their investment at current market prices.
- If production increases by +3 standard deviations above the base forecast, the lifetime distribution rises to $15 and with a ROI of 5%; even if production somehow recovers from its current dismal trend, SDR is overvalued. (Note: given that SDR's sister trust, SandRidge Mississippian II (SDT) also has dismal production, these types of increases are very unlikely.)
- If forecast sales prices rise 15% above current forecasts (measured as a gradual increase over 8 years and based on WTI, HH, and prior spreads), the total distribution rises to $9.62, meaning that investors would just barely cover their initial investment.
- If both price and production increases occur (a very optimistic assumption, indeed!), the lifetime distribution is $16.77 with a ROI of 8%.
I don't see the market price adjusting itself any time soon. But if it does, I would look to buy a little around $5.71 (8% ROI) and a lot around $5.35 (10% ROI).
SDR as a possible play in late 2014
Although the market currently overvalues SDR, it does not necessarily make the stock a good short candidate, especially as the stock already had one huge plummet in 2013. There are three factors that work against possible short strategies at the current time:
- SDR's robust trailing yield - and hope - will keep uninformed investors in the stock. Face it, there are some investors who will look at the trailing yield and stay long, even if they know that the good days are going to end.
- There are no near term triggers that might result in a market price adjustment. SDR is a trust and issues only scant production numbers and a boilerplate report every quarter. It does not issue future guidance. Until the distribution actually drops, there may be upward pressure on the market price.
- SDR is relatively illiquid. As compared to large cap stocks, SDR has fewer available shares, lower trading volume, and fewer shareholders, many of whom are "buy and hold" investors. Simply put, a short investor with a large position could have difficulty buying on a drop because they could push prices up.
Looking forward, there might be a few possible plays on SDR in late 2014 or 2015. For example, if SDR's market price retreats in 2014, tax-loss selling in late December 2014 could open a buy opportunity. Investors interested in a long position may wish to take another look at SDR after it issues Sep-14 results in November and set possible target buy prices after the distribution is locked in the middle of December.
Alternatively, SDR's price may stay high or increase in 2014. If SandRidge completes its drilling program during the June 2014, the Sep-14 and Dec-14 quarters may experience substantial declines in production and, by my estimates, one or both may fail to meet the subordination threshold. Such a failure could trigger a decline in share price. Investors interested in a short position should seek to reevaluate SDR when Jun-14 quarterly results are published in July 2014 for possible plays in late 2014.