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Summary

  • Anti-fracking ballot measure in Santa Barbara creates confusion.
  • As is sometimes the case, confusion has created a buying opportunity.
  • We project that monthly dividends will remain unchanged and units will appreciate over time.

Thesis:

Pacific Coast Oil Trust (NYSE:ROYT) units of beneficial interest have declined by over 40% during the past twelve months and currently yield in excess of 15%. The obvious reason for the decline is the Healthy Air and Water Initiative to Ban Fracking (otherwise known as Measure P) that will be on the Santa Barbara County ballot for the November 4th election. The stated purpose of the initiative is to ban fracking and to prevent future development of the rumored 10,000 new oil wells in the county. Based on extensive research, we believe that the most likely outcome is that Measure P fails.

Opponents of Measure P do not want to simply make Measure P a referendum on fracking. Given the public's negative image of fracking, it is a weak hand to play. Instead, the opponents are highlighting that Measure P could in theory result in halting all oil production from the county's existing 1,200 wells, including 220 belonging to the trust. That argument is powerful and resonates well with the voters, who clearly want existing production along with the jobs and tax revenue it provides to continue.

Whether Measure P actually bans current production in reality is a different story. California law clearly recognizes the concept of vested rights, the right to continue operating in a location and in a manner without being required to conform to subsequent land use restrictions. Given that, it is quite difficult to close down an existing oil well simply through a ballot measure.

Measure P specifically includes an exemption for holders of vested rights to continue production. Supporters of Measure P often highlight that exemption and repeatedly claim that current production is not affected. They do that because they know the voters want existing production to continue. The legal debate is what constitutes a vested oil right. Finally, the measure would surely be subject to substantial expensive litigation (from state law preemption to takings claims) if in fact it stopped existing production and therefore potentially result in large liability to the county.

The fear among ROYT holders that the residents could inadvertently be tricked into causing all current production to permanently cease is in our opinion absurd. The fix is simple. In the event the Measure P passes and the mechanism that the initiative has to allow current production to continue fails, the wording of the Measure P could be amended in a future ballot initiative in June 2015. The new initiative would clarify the voters' actual intent: banning fracking, limiting the growth of new oil wells, and allowing current production to continue. A new initiative would simply add the definitive words "existing operations" to the ambiguous "vested rights," in section 5.C. In the interim, the likely case is that production on the trust property continues unchanged. The cost of a new ballot measure is de minimis. Oil production in the county produces approximately $1 million in revenue a day, while the cost of a new ballot initiative in total is less than $500,000.

Therefore, we think that unitholders will continue to earn 15% per year from monthly distributions. As the confusion around Measure P is resolved over the next twelve months, we believe that unitholders will earn significant additional return through capital appreciation.

Background:

Value investors are always on a search to find a gap between intrinsic value and current market value. One segment of the market where we have found large discrepancies is royalty trusts. The irony is that royalty trusts are generally one of the easiest securities to value. One reason for the gap is the owners such as retail investors and funds that focus on dividends tend to be extremely myopic, valuing the security strictly based on recent or forecast distributions. The other is the lack of quality investment research available to guide investors. The result is that misinformation in the market place tends to have a dramatic effect on market price. One example of first phenomenon is Whiting USA Trust 1 (NYSE:WHX). Following Shane Blackmon's aptly titled article on seekingalpha.com, "You Will Lose 50% of Your Money If You Hold This Trust", shares of WHX did exactly that. The article simply noted that the terms of trust explicitly stated that the quarterly distribution would soon end.

On the other hand, misleading articles in the media can also cause the gap between intrinsic value and market value to actually widen. Blackmon followed up his accurate analysis of WHX with an article on BP Prudhoe Bay Trust (NYSE:BPT). The latter analysis contained several obvious errors that led him to undervalue the intrinsic value of BPT. Wall Street Journal Columnist Jason Zweig repeated those same errors in his August 24, 2012 column titled, "Will These Royal Yields Rule?" Following Jason's column, shares in BPT promptly fell more than 35%. As the concerns that Blackmon and Zweig articulated failed to materialize, the shares have regained most of that lost.

ROYT is an example of the latter phenomenon. Although there is not one particular article that has caused the collapse of ROYT unit price, there are a variety of misunderstandings and causes for them. Those include:

Trust structure. The trust's structure contributes to the information black hole. ROYT units are a beneficial interest in a trust and not shares of a publicly traded company. If this were a publicly traded company, management would be informing shareholders of the reality of the situation and likely outcomes. On the other hand, the trust is administered by Bank of New York Mellon. Sarah Newell, the Bank's case officer, is unfamiliar with the underlying properties, has likely never visited Santa Barbara's Orcutt field, and is not a legal expert on vested rights. The trustee simply inserts a blurb from the operator, PCEC, about the issue in the monthly press release and the 10Q. There are not conference calls with the trust department or investor days with the operator's management. Given that operator's management is purchasing shares in the trust at current prices, there is no incentive for them to give a positive outlook. Neither the trustee nor PCEC want to offer an optimistic outlook and later get sued.

Californian stereotype. We believe that investors are assuming based on Californian stereotypes that its voters will approve the measure. Getting a measure on a ballot is not an indication of its probable success. It is as easy as standing outside of places such as Whole Foods with a Healthy Air and Water sign. Had this initiative been on the ballot in North Dakota or Alaska, stereotypes would lead investors to conclude that it would not pass.

To some, the stereotype of Californians is hippies and Laurie David "Inconvenient Truth" types. The reality is that California is far more diverse. The state's most famous politician in the past thirty years is Ronald Reagan. He loved his ranch in Santa Barbara and small government. At his inauguration, he said, "government is not the solution to our problem; government is the problem." The scientific community generally views water flooding and cyclic steaming as safe. Given that, we believe Reagan would have been against more government regulation and would have been for production.

There are many other pro-oil politicians in California. The Santa Barbara Board of Supervisors has repeatedly approved new oil wells. The state legislature considered two anti fracking initiatives in the past few years. They both were defeated.

Pacific Coast Oil Trust's History:

ROYT founders' Hal Washburn and Randy Breitenbach initially met as roommates at Stanford University in the early 1980s. After graduation, they formed a company that sought to acquire high quality petroleum assets: long lived fields with significant oil in place and low decline rates. ROYT's fields are exactly the type that Washburn and Breitenbach initially sought: incredibly stable and long-lived. The production from the two fields that ROYT receives royalty from rarely varies:

Month: Sales Volume Boe

June 2013: 129,000

April 2014: 132,800

May 2014: 135,600

June 2014: 133,000

The Trust went public in May 2012 at a price of $20 per unit. The trust receives revenue from two groups of wells: developed properties and remaining properties. The Trust receives 80% of the profits from the developed fields and 25% from the remaining properties. The Trust's developed fields include 66 in the Los Angeles County area and the remaining 220 are located in the Orcutt field in Santa Barbara. The Trust properties are operated by Breitenbach and Washburn's Pacific Coast Energy Company. Pacific Coast has similar ownership and management as Breitburn Energy. Breitburn Energy Partners (NASDAQ:BBEP) announced on July 24th that it is going to acquire QR Energy for $3.0 billion. The merged entity will be the largest upstream energy partnership.

History of Unit Offerings:

Date Number of Shares Price

May 8, 2012 18,500,000 $20.00

September 18, 2013 13,500,000 $17.10

June 10, 2014 2,654,000 $13.00

While management was indirect sellers in the first two offerings, they actually were net purchasers in the third. Randall Breitenbach increased his ownership from 220,000 to 476,000. Harold Washburn's holdings went from 590,000 to 846,000. And Mark Pease, the President and Chief Operating Officer of Breitburn Energy, increased his holdings from 261,000 shares to 376,000.

History of Measure P:

Oil has been produced in Santa Barbara County for over 100 years. There are currently about 1,200 active wells. Oil production generally takes place in the northern, unincorporated, industrial part of the county. Residents in the north support the industry, as it provides jobs and tax revenue. The wealthy part of Santa Barbara is 70 miles south, including Oprah Winfrey's mansion and Al Gore's villa in Montecito. When either venture out, the likely case is that they travel south to Malibu and Los Angeles.

The Santa Barbara Water Guardians led the drive to put the initiative on the ballot. The initiative has two publicly stated goals: ban fracking and prevent the exponential expansion of the oil industry in the county. In reality, there is no need to ban fracking, as no fracking is currently ongoing or being proposed in Santa Barbara. The Water Guardians simply use the general public's current fear of fracking to increase support for the measure.

The same misdirection is behind their choice of name for their organization. Currently, there is a drought in California. It is true the production of oil in Santa Barbara uses large quantities of water. But ROYT's oil production does not use drinking water. Instead, it uses wastewater and water from the drilling process itself. And onshore oil production in the county has never contaminated the county's drinking water. So in reality, there is no practical need to ban fracking or protect the water.

The potential for a dramatic increase in the number of oil wells in Santa Barbara County is a valid fear. China-based Goldleaf Jewelry Company recently acquired one of the large Santa Barbara operators, ERG Resources. Goldleaf retired ERG's high coupon debt and provided them additional capital to increase production. With funding from Goldleaf, ERG could drill thousands of new wells.

Former tech entrepreneur Katie Davis is the unofficial leader of the Water Guardians. Her accomplishments include securing a pivotal $3000 grant from the Fund for Santa Barbara to keep the Water Guardians afloat. She has donated $10,000 of the total $44,000 the group has raised to date.

The Water Guardians are going to great lengths to claim that Measure P does not affect current production. We believe that they are doing that because they realize that the voters want current production to continue.

From their website's FAQs:

Q: What does the initiative specifically prohibit?

A: The initiative does not apply to current oil production or conventional drilling...

The lawyer that drafted Measure P is Rachel Hooper of Shute, Mihaly, and Weinberger. She recently stated in an interview in the Lompoc Record that the initiative is intended to be prospective. She said, "they (the prohibitions) would not apply to and would not shut down current production."

And finally, voters will receive an official packet for Measure P along with their ballot. The supporting materials emphatically state that, "Measure P does not affect current oil and gas projects. Existing oil and gas projects will continue to operate as usual."

We believe that Measure P will fail:

  1. Current polling shows less than 50% support. Given that Measure P is a local initiative, one cannot use Google to find a predictive poll. But from our research conducted in Santa Barbara, we believe that polls exist that show current support at less than 50%. Importantly, support for a ballot measure tends to decline towards election day.
  2. The oil industry will easily outspend the Water Guardians 10 to 1. The Water Guardians are operating with limited funds. Owners of existing wells have a $3 billion asset to protect. In addition, the No On P group is drawing financial support from the world's largest oil producers.
  3. Fracking and water problems are imaginary threats, whereas lost property taxes, employment taxes, and jobs are real possible negative outcomes.
  4. The coalition against Measure P is broad based, from businesses to unions.
  5. Measure P is unofficially known in Santa Barbara as the Lawyers Full Employment Act. If it passes, it will undoubtedly create millions in fees to lawyers. If the oil producers win in court, the county will have to pay millions in damages. If the environmentalists win (such as appealing an exemption), California law provides their lawyers' fees.
  6. The County Board of Supervisors' voting records are a good proxy for how the voters themselves feel, as the five members are elected officials. The Board has been approving new wells because that is what the voters want.
  7. The previous initiative on the Santa Barbara County ballot was Measure M, which failed. Measure M mandated increased spending on roads, parks, and buildings. The voters did not want the financial liability associated with the initiative. Measure P creates even greater financial uncertainty than Measure M, and that is one reason why we believe it will fail.

In The Unlikely Event That Measure P Passes:

If Measure P passes, production should continue because of the concept of non- conforming land use and vested rights. In California, land use restrictions only apply to future development and not existing structures. One often sees examples of this along the California coast where buildings constructed long ago still stand that would not be allowed today. In Los Angeles County, Maestro's Ocean Club is a delicious steak house and one of the few restaurants located west of the Pacific Coast Highway. Current land use restrictions would clearly prohibit its construction today, but given that the building is grandfathered in, the restaurant continues to operate and often receives the needed permits required to do so.

The Beverly Hills oil field is example A of why we believe that the current oil production in Santa Barbara will continue. Beverly Hills is one of the wealthiest cities in the United States. The city is home to the exclusive Rodeo Drive, homes valued in excess of $50 million, and many six-star hotels. The city does not have a need for the economic benefits of an oil field. If a California city could simply vote a producing field out of existence, Beverly Hills would have done it.

But oil production continues today, even directly under the city's high school using water flooding. Concerned parents of students did try to mount a legal challenge. They were represented by Erin Brockovich-Ellis' law firm, Masry and Vititoe. The lawsuit asserted a range of health concerns, including increased risks of cancer. In 2006, Judge Wendell Mortimer Jr. dismissed the case. In 2016, production under the high school will finally cease, but that is only because the operator's land lease with the city is scheduled to expire.

The confusion about the effect on current production can be seen at meeting that the county conducted in response to Measure P being placed on the ballot. During this July 29th meeting of the Santa Barbara County Board of Supervisors, each side offers a starkly different assessment.

The speakers with Yes On P stickers claim that current production is completely unaffected. For example, at minute 46, the lawyer representing the Water Guardians, Maggie Hall of the Environmental Defense Council, says that Measure P, "provides an express exemption for owners of existing production." Those with No on P stickers stated the exact opposite. At minute 32, Latham and Watkins attorney George Mihlsten directs the Board to ask its staff to confirm his legal analysis that Measure P bans all production.

What Mihlsten does not mention that day is his previous representation of Breitburn Energy and Pacific Coast Energy Corp. Given that, he has probably been engaged by them to help with the current fight against Measure P. Again, it is hard to campaign against Measure P on a pro fracking stance. Instead, its opponents have chosen to target something the voters do care about: the $20 million in tax revenue that the county currently receives from oil production. If in fact Measure P eliminated current production, that tax revenue would be at risk.

Santa Barbara County Council Mike Ghizzoni did not in fact concur with the Mihlsten argument. Ghizzoni took the middle ground and cited the landmark California Supreme Court case, Avco Community Developers vs. South Coast Regional Commission. He applied the Avco standard to the current bill and concluded current production is allowed to continue. While some of ROYT's development wells might be prohibited, those are of significantly less importance. ROYT only receives a 25% royalty on them, vs. an 80% on the existing wells. The other major vested rights case decided by the California Supreme court is Hansen Brothers Enterprises, Inc v. Board of Supervisors. We believe that under the Hansen Brothers standard, current production would be considered a vested right.

The Santa Barbara County Planning and Development Department meeting on Friday August 8th also confirmed that current producers should have a simple route to receive permits to continue production from the Director. The Planning Department released a copy of the draft ordinance. Section B2 specifically states that the Director will be authorized to issue exemptions for current producers.

On Monday August 25, the Montecito Planning Commission will have a special hearing to discuss Measure P. One can see from the proposed ordinances available online along with other supporting materials that a direct path for existing producers to receive exemptions from Measure P will be available.

For example, Attachment B - Notice of Exemption provides a straightforward path for current producers to receive an exemption from Measure P. Importantly, it states that, "The Director shall not take any action to enforce the Initiative against any owner or operator of an existing facility if an application for a Determination of Exemption has been filed with the Department and the application has not expired or final action to deny the application has not occurred."

Given that a denial would be reviewed by the Planning Commission and then by the Board of Supervisors, it would take a substantial amount of time before one would become actually effective. In the interim, a new ballot measure could be initiated and passed.

The Vested Rights Debate Is Actually Moot:

We have initiated a long position in ROYT not just because we think that Measure P will fail or our belief in vested rights. Our position in ROYT is based on the overwhelming evidence that the voters of Santa Barbara County want current oil production to continue. If we are wrong on both the voting outcome and vested oil rights, we think the voters will correct Measure P's legal language in a future initiative.

Risks:

There are many risks associated with investing in ROYT. Those include:

  • Oil Price. ROYT does not hedge its production. Therefore, monthly dividends are tied to the WTI price.
  • Earthquake. ROYT receives royalties from two fields. If either one is impacted by an earthquake, it would cause monthly distributions to drop.
  • Judicial Process. The US legal system is inherently unpredictable.
Source: Pacific Coast Oil Trust: Regulatory Fears Unfounded, While Units Yield 15% And Sell At A Discount

Additional disclosure: We have partially hedged our position with out of the money puts.

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