Whiting USA Trust: The Last Reason To Own It Is Gone

Mar. 7.14 | About: Whiting USA (WHX)

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Let's talk about Whiting USA Trust I (NYSE:WHX). We all know it's trading too high. There have been several recent articles on this stock already (see here and here, for instance). I wrote one myself about a year ago, and there were several good ones going back several years. I think at this point most investors that play around in the royalty trust space realize that this stock is significantly overvalued.

I think it's safe to say that the fact that WHX is trading around $5.50 (at the time of this writing), yet you're only going to get around $2.20 in distributions and then be holding a worthless asset is not off of anyone's radar anymore. The questions that keep arising are how can this possibly still be the case when everyone knows about it, and how long can this go on for?

First, the obligatory paragraph of recap for anyone reading about this stock for the first time :

WHX is an oil and gas trust. It receives 90% of the profits received from producing 9.11 MMBOE. So far it has produced 7.911 MMBOE. After hitting 9.11 MMBOE the trust will terminate, which is expected to happen by March of 2015, with the last distribution being paid out shortly after that. At that point the trust has no residual assets and is worth zero (this is easily confirmed with the latest 8-K). That last part bears repeating: the trust doesn't own the wells - the only assets in the trust are the net profits interest in the wells. So the only payouts that a shareholder will receive are from the sale of the oil and gas until 9.11 MMBOE are produced.

We can split hairs over what the value of the remaining distributions is going to be, but there's only a few left so let's just do a quick estimate. 7.91 of the 9.11 MMBOE have been produced and sold. Last quarter 303,356 BOE were produced which resulted in a distribution of .557 a share. If we expect similar costs and prices, this would imply 3.95 more quarters like the last one, and payouts of $2.20 total for the life of the trust. I actually think it will be less than that, but we might as well keep our estimate on the high side - it's not really going to matter.

OK, so the total payouts are going to be around $2.20. The present value is obviously less than that. I mean, why would anyone pay $2.20 now for the right to get $2.20 back over the next year ? That trade itself makes no sense, so paying north of $5 really makes no sense. So why is WHX trading this high? The answer, as ridiculous as it sounds, is because it's trading that high. The entire house of cards is held together by the stock loan rate. It works like this:

The average retail investor doesn't get anything when their shares are loaned out. But some places, like Interactive Brokers for example, will give you some of it, maybe half of what a short seller pays to borrow it. Larger investors can get a larger percentage, say 80% of the rate. So what happens when a stock is trading way too high (like WHX is now, for instance)? Everybody wants to short it, so they scramble around trying to find stock to borrow. The borrow rate can go to maybe 100%, meaning on an annualized basis the short seller is paying 100% of the stock price to stay short (the daily cost of which changes as the stock price changes). The long investor who's holding that stock might be getting paid 80% to be long. So in addition to receiving the distributions he's also getting a significant payout on the interest. When the stock goes up this obviously means the longs make more in interest. So you wind up with a weird situation where as the stock gets more overvalued it becomes more advantageous to own it and lend out your shares, giving investors more incentive to buy it. The catch to being long in that case is obviously that it could unravel at any time, and actually, in the case of WHX, is certain to happen at some point, since the stock is going to zero in a year.

So how does this play out? The only reason anybody is paying anything at all to borrow the stock is because it's trading too high. If it were trading for fair, why would anybody want to short it? At some point somebody who owns the stock will decide they don't want to be the guy with no chair when the music stops, so they'll dump their position. That'll trigger some stops and then we'll get a big selloff and probably get down to fair. When that happens, it's over. Once it gets down to fair value, there's no reason to be short it anymore. When there's no reason to short it, there's no reason to own it either - if there's no demand for the borrow, the stock loan component disappears.

Previous authors have compared WHX to GNI, and it's a good comparison. They're both royalty trusts terminating around the same time, they're both pretty easy to value, and until GNI crapped out recently, they were both trading way above fair with a high cost to borrow. About a month ago, GNI tanked - $70 to $20 in a few days. Now it's trading down around fair, there's no reason to short it so the borrow cost has come down sharply. This results in a different type of equilibrium: buyers and sellers are valuing it by the actual payouts you're going to get and how much you'd pay now to get those payments in the future. You know - the way you'd expect a trust that's terminating would be valued.

It seems obvious that the same thing is going to happen to WHX. One author went so far as to say that because it already happened in GNI it's going to happen any day now in WHX (see here). I don't necessarily love that logic, but you have to wonder when is that moment for WHX?

Tough to say, but here's how I'm looking at it. If I were long and could lend out my stock, what would I think I'd be getting?

It looks now like there will probably be four more payouts of roughly .55 and that'll be it (my model has it as a little less, but let's keep the math easy). So as of now you're going to get $2.20 in payouts; .55 in May, Aug, Nov and Feb. When there's one payout left, I just don't think there's any way this will still be trading above fair. I know people will argue about that with me, but there just won't be any confusion at that point about what you're getting - even the people living under a rock will have to finally wonder why their stock is almost zero and do a little homework. And nobody's going to play the greater fool game with 3 months left either. So I'm assuming that for the last quarter, stock is trading fair and so I'm getting nothing back for lending out my stock.

Let's say in a really optimistic scenario, stock trades around the current level ($5.50, 2.5 times fair) until the next dividend. Then say it trades at twice fair value for the two quarters after that ($3.30 and $2.20). I don't actually think there's any way it'll hang in there that long, but let's say this is a best case scenario if I'm long. Let's also say that I can loan out my stock and get 80% back. Again, a very optimistic scenario since you probably can't get that now, and stock loan demand will decrease as time goes by and stock goes down.

You crunch those numbers and you wind up with $1.98 in interest and $2.20 in divs, for a total of $4.18. But stock is trading $5.50.... Why would I pay $5.50 for stock today to get back a total of $4.18 over the next year (and need everything to go unrealistically well for that to even happen)? Good question.

In fact, if WHX stays at an average of $5.50 almost the entire time - until the November dividend (when there's only one payout left), you'd still only get $5.30 back in interest and divs. Think about that one for a minute: for that to happen you'd need the stock to trade 2.5 times fair value for a quarter, 3.3 times fair value for another quarter, and 5 times fair value for the third quarter. And get 80% loaning your stock out. And even if all those things happen you'd still lose money!

You used to be able to make enough on the stock loan to justify owning WHX at inflated prices. Even as recently as a few weeks ago, when there was another dividend left, you could mess around with your assumptions and come up with a situation where you might still be winning. But not anymore. Now you can't really create a scenario to justify owning the stock. If you take the stock price up in your assumptions, your total payout just diverges farther from the stock price (meaning you eventually lose more by being long). What used to be a valid reason to be long - loaning out your stock - isn't there anymore. There just isn't enough time left.

And that's what I think is going to be the lightbulb-going-off moment for the longs. It's not that they finally realize that the trust is going to terminate in a year - everybody knows that by now. It's not that they finally figure out that they're not going to get $5.50 in divs - everybody knows that by now, too. It's the fact that the stock loan part of the trade, which worked so well for so long, isn't going to be enough to cover how much they're going to lose as we approach the termination date.

Disclosure: I am short WHX through stock and options. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.