(UPDATE: please see below link for my publicly shared model for BPT. You can download the Excel by clicking the download or down arrow button from the google doc. Please comment on the article or message me for any questions or comments: http://bit.ly/1uPdRKA)
With the stock market flying and interest rates near all-time lows, many asset classes have become severely overvalued. It is often difficult to ascertain how overvalued they are though. Many MLPs and REITs, among other things that trade on yield, are at absurdly low levels. Unlike MLPs and REITs, which use a complicated series of equity raises, debt raises, and acquisitions to muddle up true organic operational performance, some Royalty Trusts are much cleaner and easier to evaluate and see how undervalued they are as most do not do any growth projects and only distribute the cash flow of the current project. The BP Prudhoe Bay Royalty Trust (NYSE:BPT) is one such trust.
The BP Prudhoe Bay Royalty Trust consists of an overriding royalty interest in the working interest of BP Alaska as of February 28, 1989 in the Prudhoe Bay oil field located on the North Slope in Alaska. This entitles the trust to a royalty on 16.4246% of BP's working interest (based on their working interest as of February 1989). The other partners in the project include Exxon, ConocoPhillips, and Chevron.
Based on the 1989 splits, BP owns roughly 44.5% of the oil and 12.1% of the condensates in the field. The BP Prudhoe Bay Royalty Trust is entitled to a royalty on 16.4246% of this ownership.
Revenues are allocated to BPT based on actual production and priced at WTI but they are also allocated a series of costs: chargeable costs grossed up by a cost adjustment factor (both of which have annual escalators) and production taxes. The chargeables have a clear schedule that is published in the 10-K including into the future. The adjustment is based on CPI. I have assumed 2% inflation to determine the adjustment factor and the costs are as follows:
|Year||A. Chargeable cost per barrel||B. Cost Adjustment Factor||C. Adjusted Chargeable Costs (A*B)|
As you can see, the costs begin to escalate pretty severely over the next 10 years and as we will see, severely reduce the distributable cash flow in the future.
Production taxes are a little more confusing. As per the 10-K, the Alaskan government has made several different changes over the years. Based on my reading, the tax will for 2014 be a 35% tax on gross receipts - gross value at the point of production for the calendar year less the producer's direct costs of exploring for, developing, or producing oil or gas deposits located within the producer's leases or properties in Alaska. BPT released their latest 10-Q and distributions have been higher this year with the new tax law in effect. Based on where their Q1 taxes came out, it appears as though BPT paid about 25% of WTI less adjusted chargeable costs. Their is a current protest regarding this tax law change but I have stuck with this formula going forward.
Based on the 2013 10-K, as of 12/31/2013, BP estimates remaining reserves allocatable to the trust of 71.546 million barrels including 64.748 proved developed and 6.798 proved undeveloped. From 2009-13, oil recoveries have decreased by an average 2.09% and condensates declined by an average of 8.41%.
Going forward, I project the oil recovered to reduce by 2% each year and the condensates by 6%:
|Year||Total Field||NWI - BP||Total Field||NWI - BP||Annual Barrels Attributable to Trust||Total Barrels Remaining - Trust|
As you can see, the trust should run out of oil around 2031, however based on the cost escalations, the trust won't remain profitable until then. I have made some rough estimates of WTI based on the forward curve. You can see that by 2025, the trust is losing money per barrel:
|Year||WTI||C. Adjusted Chargeable Costs (A*B)||D. Production Taxes||Average Per Barrel Royalty (WTI less C less D)|
Putting revenues and earnings as follows:
At an 8% cost of capital, this discounts to 44.50.
One issue with shorts like these, is that the discount rate may not really matter if in absolute terms you lose money and with a terminating royalty trust, there will be distributions for the near future. So I wanted to look at what is the IRR that the royalty trust is currently implying? It is actually -8% (with BPT @ 92.49). Essentially, the sum of all the undiscounted earnings is less than the current firm value. The sum of all future cash flows undiscounted are $1.327 billion or $62 / share.
There is an energy consultant, Miller and Lents, who has done some analysis on behalf of the BPT trust. They have an alternative calculation that shows undiscounted net revenues of $2.4 billion and discounted revenues at $1.5 billion. I am not clear how they are coming to these calculations and have reached out to both consultants who signed the report to see if they can provide any insight without luck. It also mentions they believe that the trust will continue to be paying royalties through 2029 with WTI flat at $96.78 / barrel. I am confused how they have come to this conclusion as it is contractually stated in the BPT agreements that the chargeable cost will be 51.25 in that year. Even assuming only 1% inflation, the cost adjustment factor would rise from 1.8 (end of 2013) to 2.11 (in 2029) thus making adjusted chargeable costs (2.11*51.26) = 108 which is greater than their WTI assumption. I am not sure if they are missing something or if I have missed something but appreciate any advice or thoughts if someone else has noticed anything. Barring some massive increase in the price of oil, a big increase in the production throughput (especially sooner rather than later while costs are still low), or some devil in the agreements which I have missed which allow them to lower their future costs, I think this is a clear short / mispricing in the market.
It could possibly take a few years for the market to see this mispricing as costs do not really start escalating until a few years down the line. That is one of the bigger risk as one has to eat the cost of borrow (6% for me) over a few years until the market prices it correctly (also big risk is WTI prices rising).
I think it should be noted that, especially in a short, all an analyst can do is present the facts and analysis. They cannot control the stock price. Just because a stock goes against you does not mean you were incorrect in the same way just because the price goes with you does not mean you are correct. It is all about making the best probability weighted assessment with the information at hand. What makes shorting even more difficult is the ability for an acquirer to come in and pay above intrinsic value blowing up the idea even if the analysis was sound. As a royalty trust, M&A is not an option so there is some safety from that in this idea.
Disclosure: The author is short BPT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The fund I manage is short BPT, not me. personally.