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Summary

  • DOM’s production levels are declining and the trust is likely to close in 4-5 years.
  • Wells are being shut and a vast majority of wells may be losing money.
  • DOM’s own 2014 reserve report suggests a fair value of $2.64; 75% lower than Monday’s opening price.
  • Separate analysis of production and pricing suggests that, even under highly optimistic assumptions, DOM is 36% overpriced.
  • Put options appear very attractively priced.

Author Update Fri, May 29, 2:51 PM

Update (28 May 2015) 

So, it's been almost a year since this thesis on DOM was published.  How have things played out? 

First and foremost, the put option play turned out to be quite a winner - 20x! DOM's current market price remains well below the highs seen in early 2014 and is unlikely to ever see anything near those levels again. It recently dropped to $4.50 following a cut in the distribution and could decline further.

Second, the fundamental valuation of DOM shows that future distributions are insufficient to justify even today's market price. Regardless of which of the two valuation methods applied (trust reserves or my own model), DOM's future distributions, including any residual payment at termination, are worth between $1 and $3 today.

Third, DOM's termination has been stayed, for now. 2015's high gas prices increased the perceived remaining economic life of the wells in the eyes of the reserve auditors. At this point, I expect reserves to see a sharp negative adjustment at the end of this year, but not enough to trigger the termination clauses.

So where to from here? On one hand, DOM is overvalued as based upon its underlying distrubution. But I'm not bearish at current prices, at least for the near term. For one, I don't see an obvious downward trigger. The model suggests that DOM's recent 9.8-cent distribution is the bottom and that it will rise slightly moving forward. And Walter's efforts to shut wells are widely known and appear to be staying the course. Two, option income and short rebates could make holding shares of DOM economical for some traders at current prices, meaning that there could be upward price pressure. And an upward price swing could easily squeeze out some of the current shorts.

Good luck to all.

Dominion Resources Black Warrior Trust (NYSE:DOM) is an all-gas trust that owns royalties to wells in Alabama operated by a subsidiary of Walter Energy. DOM's revenues, yield, and NPV have all benefited from the recent rise in natural gas prices and its shares, which are openly traded on the NYSE, have doubled this year, from $5.50 in early January to a high of $11.00 during Monday's session.

However, the market price rise has exceeded any possible price and production upsides. DOM's wells are in their twilight years and Walter Energy has begun the process of abandoning them. DOM's own reserve report suggests that the trust may have a lifetime of only 4-5 years. Estimates from this reserve report, and my own separate analysis, show that the shares are grossly overvalued, offering a downside of more than 75% to the current price of $10.99.

Production levels are declining and the trust is likely to close in 4-5 years

In the most recent quarter (March 2014), DOM's gas production reached an all-time low of 429 mmcf, representing a 14% decline from two years ago and a whopping 50% decline from 7 years ago. These results are not outliers; as shown in the following chart, March's results are part of a consistent and continuing trend of declining production. From 2005 to 2012, production declined at an average of 10.7%/yr, improving to "only" a 5.5% decline since. The forecast in the chart extends this 5.5%/yr decline into the foreseeable future.

Production History and Forecast

Fig. 1: Historical and forecast production. Source: DOM SEC filings and author's analysis.

Declining production is not just bad for the distribution, it also portends the ultimate termination of the trust. As clearly laid out in the trust's annual reports, DOM will terminate if either (1) the coverage ratio of net revenues to trust expenses falls below 120% (1.2x) or (2) the NPV-10 of remaining reserves falls below $5M. When either of these conditions happen, the trust will sell off the remaining royalty rights, issue a final distribution, and cease to exist.

Of these conditions, the one most likely to trigger DOM's termination are the reserves. As shown in the following chart, the reserve estimates have fallen sharply over the past 10 years and appear to be only a few years from hitting the termination threshold. DOM's March 2014 8-K contained formal language to this point, suggesting: "it could be estimated that the Trust still has a life span of 4 to 5 years." Based upon the last ten years of reserve report data, I would agree with that estimate.

DOM Reserves Fig. 2: DOM's reported gas reserves. Source: DOM SEC filings.

Wells are being shut and a vast majority of wells may be losing money

Along with overall production declines, Walter Energy has also begun to abandon wells. In the past two years, 22 of 532 wells were abandoned and the trust has stated that another 20 may be abandoned this year. Although the abandoned wells typically have only marginal production, the total effect of future abandonments is likely to have a notable impact on DOM's bottom line in terms of both revenues and reserves.

However, there are signs that the situation could worsen quickly. In addition to its dour reserve forecast, the 2014 reserve report also included this one nugget:

An analysis by Davis [the company retained to produce the reserve report] of the current operating conditions indicates that over ninety percent of the existing producing wells are being operated at a negative cash flow to the working interest owner, Walter, at this time.

Source: DOM 10-K (exhibit 99.2, p3) - March 10, 2014

The emphasis in the quote above is mine. If ninety percent of the existing wells are, indeed, cash flow negative to Walter Energy, it is likely that Walter may seek to abandon a great many more than 20 wells in the near future. For DOM unit holders, it is worth noting that the ninety percent of wells that are referenced here may actually be revenue positive for the trust, depending on how the various operation and administrative costs are apportioned to the different royalty owners. If Walter were to abandon even a significant percentage of these wells, DOM's production declines would likely accelerate and the trust terminate much sooner than suggested in the March 2014 8-K.

DOM's own 2014 Reserve Report suggests a fair value of $2.64; 75% lower than the current market price

So let's take a closer look at the 2014 reserve report. The report, dated January 1st of this year and published, in part, in DOM's March 10-K, estimated that the reserves as of the date of the report were 8.062 bcf with net future revenues of $26.0M and an NPV-10 of $16.8M. However, the report estimates also assume a gas sales price of $3.66/mmbtu ($3.46 after converting to mcf and applying a differential), which is well below the current sales prices, so we need to adjust these prices...

The table below shows the results from the 2014 reserve report and backs out the NPV-10 valuation for sales prices of $4.00, $4.50, and $5.00/mcf and considering production since the date of the report. Using the methodology of the reserve report, the suggested valuation for DOM is only $2.64/share, 75% below the recent market price. Noting that this value would apply regardless of when the trust terminates, it suggests that DOM is grossly overvalued by the market.

DOM valuation

Fig. 3: DOM's value based on the 2014 reserve report. Source: DOM 3/10/14 10-K and author's analysis

Even under alternate and highly exaggerated assumptions, DOM has 36% downside

Given that DOM is grossly overvalued as compared to its official reserve report, it is important to also explore how that valuation changes given different termination dates and asset values. More importantly, as a potential short, I want to know: what is the most that DOM could be worth today assuming that everything goes right for the trust's distribution?

As those familiar with my articles know, I analyze trusts using a bottom-up, engineering-style model that considers forecasts of production, sales prices, and expenses and unique underlying circumstances. For DOM, I developed a base case that uses some historical, but probably optimistic, assumptions:

  • Future well production will decline at only 5.5%/year (ignoring remaining reserves and Walter's stated intentions to abandon wells)
  • Future sales prices are based on NYMEX Henry Hub futures markets adjusted for the historical spread (-$0.05/mcf)
  • Future expense ratios for taxes, which are 6% of revenues, and administration, which is $267k/qtr, will not change
  • An appropriate discount rate for retail investors is 7%/year

Applying the model to DOM, I explored how the model's estimate of the trust's fair value would change for different assumptions regarding the trust's termination date and asset value. Here are three cases based on possible termination dates:

  1. 4-5 Years: If we assume that DOM terminates in 4-5 years, as suggested by the trust's 8-K, and that its assets are sold for the value outlined in the reserve report (less accumulated production), its NPV-7 to shareholders today would be $2.93/share and the IRR -31%
  2. 10 Years: If we assume that DOM terminates in 10 years and pays a residual at a substantial premium to its estimated remaining reserves, its NPV-7 would be $5.00/share and the IRR -9%
  3. 50 Years: If we assume that DOM produces for another 50(!) years, terminating only when revenues fail to exceed the fixed administrative fee, its NPV-7 would be $6.76/share and the IRR 2%

These results are striking. Not only are they based on highly optimistic assumptions, but even if we ignore the trust's own rules for termination and the reserve report entirely (and assume that gas prices continue to rise but that relative costs do not!), its value would be $6.76, or 36% less than the current market price.

DOM is not worth the current market price. It's not worth $6.76. It's fair value is somewhere under $3, and I wouldn't even pay that given the uncertainty cause by the "ninety percent" comment in the trust's last reserve report. Those holding long positions will make more money-significantly more money-selling shares today than if they hold them for the long term.

Risks to the valuation

Any valuation has risks, especially when it comes to oil and gas trusts. In the case of my valuation for DOM, gas prices could go higher, the trust reserve reports could be restated with additional capacity, and the sales price for the trust could be higher than the estimate in the reserve report. However, as the model's analysis shows, even with highly optimistic assumptions, the trust is overvalued. The model's results provide a buffer against unforeseen events and a level of confidence in my conclusions that DOM is ready for a fall.

Of course, it is important to also ask why the stock is trading so high. As I look at the recent price history, I see nothing to suggest uncompetitive price manipulation, but what I do see suggests that DOM's low volume and brief run, set the stage for it to be a bubble stock. A big bubble. Thrice in the past two sessions, the stock has tickled $11/share, and all three times the price has been rebuffed; this may indicate that the stock has reached an upper limit.

Put options are attractively priced

Noting DOM's sharp rise in value in 2014 and the comparatively low volume for its shares on the NYSE, DOM appears to be ripe for being a bubble stock. Put options at $10 and $12.50, both appear attractively priced. While volumes are small, I was able to get July $10 puts to trade at $0.16. If DOM were to suddenly trade at fair value before these contracts execute, they would be worth approximately $7.5, or a 47x upside!

I suggest that investors with an appetite for risk look at cheaply priced put options for late 2014 and 2015. This approach would result in a fixed downside cost (the cost of the option) with substantial upside value.

Disclosure: The author is short DOM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Source: Dominion Resources Black Warrior Trust Grossly Overvalued - 75% Downside, 90% Of Wells May Be Losing Money