- Chesapeake Granite Wash Trust announced a quarterly distribution on August 7th of $0.5796 for common unit holders based on distributable income of $20.3M, both well below year ago values.
- Production for the quarter was flat relative to the previous quarter at 674 MBOE, but far below the year earlier level of 881 MBOE.
- Trust drilling is 80% complete and expected to be finished in the 2nd quarter of 2015.
- The current traded price of the Trust is 1.74 times the latest PV-10 and reflects an implied rate of return of only 1.25%.
- This report provides details on why CHKR is considered severely overvalued.
I finally gathered the most recent data reported by the Chesapeake Granite Wash Trust (NYSE:CHKR) to perform a quarterly financial review. Honestly I did not find any surprising new information within the financial statements. The Trust still deserves a junk rating at best, and the bad news has been public for over a year. The issues facing the Trust are best summarized in these statements found buried in the notes of the most recent 10-Q:
"[T]he Trust experienced reduced production volumes throughout 2013 and 2014, largely due to higher-than-expected pressure depletion within the AMI."
To emphasize the implications of this severe point the accountants go on to say:
"Low levels of future production will continue to reduce the Trust's revenues and distributable income available to unit holders and will likely result in continued distributions to common unit holders at or below the subordination threshold."
Maybe the drilling operator, Chesapeake, has gotten their act together and cleaned up the drilling program with the most recent wells by implementing their reduced rig count, slower drilling pace mitigation program. However, you don't get much comfort from the following statement in the 10-Q, nor should you derive any comfort when you look at the trend in actual production volumes which are detailed in this report. There are definitely a lot of dogs in the active well count.
"Chesapeake is unable to predict whether these adjustments will continue to result in less pressure depletion in these areas, whether reduced pressure depletion will result in a corresponding improvement in Development Well performance or the effects on future distributions to Trust common unit holders. If well performance does not improve, the Trust's revenues and distributable income available to unit holders will be reduced further, contributing to continued distributions to common unit holders at or below the subordination threshold. Decreased well performance or lower expected ultimate recovery may also lead to further impairments of the Royalty Interests."
All this said, it was not all the cautionary language in the financials that got my attention, although it should put all investors on alert.
What caught my attention in the analysis was the high relative price currently being paid for the impaired Trust assets by investors. I was shocked when I pulled up the most recent trading data. My first reaction was, "you cannot be serious" when I saw a last traded unit price of $10.96 on the morning of August 27, 2014. This price level is 1.74 times the most recent PV-10 when adjusted for the last two quarters of production. Yet again it appears that the marginal buyer in the market is fixated on current distribution level yield and is neglecting to do the homework on how the distributions will decline substantially over time and eventually terminate. In the case of CHKR, the Trust is on the cusp of a sharp downward move in distributions. If this point were understood clearly by all market participants, in all likelihood the traded price level would be substantially lower.
Distributions Gap down in Latest Quarter, Expected to Decline Further
Chesapeake Granite Wash Trust announced its 2nd quarter results and declared its unit holder distribution on August 7th, 2014. The Trust continued to exhibit poor well performance, and additionally suffered from derivative contracts that worked against unit holders during the quarter. The quarterly results were far below the level forecast at the IPO of the Trust, and the prospects for improvement were portrayed as unlikely.
The CHKR quarterly distribution declared for production during the time period March through May 2014 was $0.5796 per unit. The distribution was 32% below target, and on a fully dilutive basis earnings did not cover the subordination threshold for the Trust. Earnings were $0.4347 per fully diluted unit, 51.1% below target. As a result, the subordinated units of the Trust (all held by Chesapeake Energy) received no distribution for the production during the quarter.
The lower distribution level is not a surprise. Trust management has previously declared that unit holders should expect below threshold distributions throughout the time period, and once the subordinated units convert, the distributions will move even lower.
Given the impaired nature of the Trust assets, the primary questions investors need to examine are how quickly will distributions decline, and what are the implications for determining a fair value for the Trust?
CHKR Earnings Performance Analysis
In the press release announcing the Trust results, management pointed to "lower sales volume and realized prices" than the estimate made at the Trust IPO as the reason that the distribution target was missed. Well performance issues continue to plague the Trust, and Chesapeake Energy (NYSE:CHK) has slowed the pace of drilling on the remaining wells to give more time to assess the situation. Chesapeake is also drilling fewer wells per AMI in an attempt to increase well pressure and expected life on the remaining wells to be drilled. However, even with this plan being put into action during 2013, the Trust still recorded a reduction of proven reserves of 6,220 MBOE per the most recent PV-10, a very poor indication of any progress. And the most recent 10-Q still references well performance issues in 2014. For reference, the recorded proven reserve reduction in 2012 was 9,975 MBOE. The revisions make CHKR the worst performer based on downward proven reserve revisions when compared to the other Trusts that I track on an on-going basis, which include the investor despised SandRidge group (NYSE:SDR) (NYSE:PER) and (NYSE:SDT), and the equally underwhelming performer ECA Marcellus (NYSE:ECT).
When you look at the market dynamics from the perspective of well performance since IPO, you might begin to share my suspicion that the traded value of CHKR units might be out of whack when compared to its peer group. In order to prove this claim, however, more in-depth understanding of the relative performance and value underlying the unit needs to be reviewed.
During the most recent quarter, production volume was 674 MBOE, down 23.4% from 881 MBOE in the same production period in 2013 and flat when compared to last quarter.
Distributable income for the most recent quarter was $20.3M, which is 21.6% less than the earnings result a year ago. The August distribution was based on production from March through May. The recent quarter results were helped by higher natural gas prices compared to the previous year which softened the major drop in production volume. With the harsh winter in the Midwest and on the East Coast, prices for natural gas and NGL products spiked to levels not seen in years. However, in the summer months, both NGL and natural gas prices both settled down to lower levels, and upcoming distributions will be hampered by the lower price levels.
In addition to the drop in production which negatively affected the Trust in the past two quarters, derivative contracts continue to constraint distribution potential for unit holders. In the latest quarter, the Trust posted a loss of $2.383M on derivative contracts related to oil and NGL production. The loss amounted to a 10.5% drop in potential income available for distribution. This issue will be reviewed in more detail in a section below.
In the graphic below you can see that drilling has been slowed by Chesapeake in recent quarters compared to the pace set during the early life of the Trust in 2012. Currently drilling is expected to be completed by June 2015.
Drilling completion by June-2015 means that subordinate shares will convert to common beginning with the November distribution in 2016. The IPO prospectus projected that the end of subordination could take as long as the June 2017 quarter.
The Trust has 25 equivalent wells remaining that Chesapeake is responsible to drill. The un-drilled wells represent 21% of the total new wells drilled by Chesapeake since IPO the Trust has contracted to have in production when drilling is completed.
Production Mix Analysis shows Oil Output Temporarily High
The PV-10 published in the 2013 CHKR 10-K showed a slight decline in oil to 11.4% in the long-term production mix expected in the remaining proven reserves. The most recent quarters, however, continue to show a higher concentration of oil in the product mix composition as new wells continue to be brought on-line. This phenomenon is typical in "fracked" wells, where the initial oil output is high and declines very quickly over the first year.
The short-term trend has been toward greater oil production on a weighted average basis as MBOE volume is augmented by the initial gush of higher value oil in the production stream. However, the impact is expected to dissipate through time based on documented reports published by the Trust. Overall the oil output of CHKR wells continues to show a steep decline year over year (16.7%) as oil MBOE was 110 MBOE in the latest quarter versus 132 MBOE in the same quarter in 2013.
Overall the composite average delivered price by the Trust declined by (7.0%) in the 2nd quarter even though oil volume and prices were relatively higher. In the table below you can see the actual delivery prices for oil, gas and NGL during the past year.
The change in NGL prices realized for Trust production is the main contributing factor for the downward move in price over the past quarter. The average delivered price at the Trust was $35.07 in the March through May production quarter. (Note, the negative impact of oil SWAP contracts are not reflected in the oil price level).
Trust Derivative Position Analysis
The Chesapeake Granite Wash Trust has a majority of its liquid production hedged presently through December 2015 - which coincides very closely with the estimated timeframe that subordination protection to common unit holders will end.
The bad news about the derivative position is that it is currently a negative drag on the Trust earnings potential as shown in the table above. Based on the forward pricing curve as of 8/26/2014, the estimated negative impact on Trust earnings through Q3 2015 is currently $(5.24M). This value changes as the market price of oil traded on the NYMEX fluctuates.
The Trust does not hedge natural gas prices, and the general price improvement trend in the market has flowed through to the Trust's earnings in recent quarters; however, not as much as investors might expect because the Trust pays a very high differential for the delivery of gas products. In the past several production quarters as seen in the graph below, increases in natural gas prices have aided the results posted by the Trust.
In the most recent quarter, the weighted average delivered price for production at CHKR of $35.07 was higher by 10% when compared to the same time period in 2013. The reason for the increase can be traced to higher prices across the board - oil, NGL and natural gas. However, the current market price trend is for the winter of 2014 spike to revert back to price levels exhibited in early 2013. Because of the oil swap contracts in place at the Trust, any movement in the price level of oil is off-set by the change in derivative contract value which locks in the selling price of oil at approximately $88 per barrel through 2015. Improvements in NGL price levels relative to oil are valuable to the Trust as the over hedged position in oil was taken on with the expectation that the delivered price of NGL would be 50% (2:1) relative to oil. At the present time, and as has been the case for several years, the delivered price level for CHKR's NGL products continues to be around $30 per BOE. There was a brief spike upward in the winter of 2014 as shown in the above graph which briefly helped the overall realized price level.
On March 14, 2014 Chesapeake Granite Wash Trust published its 10-K report which contained an updated standardized measure of proven reserves (PV-10). The new report showed continued very poor drilling results. As shown in the table below, the total reported net reduction in proven reserves since the IPO of the Trust in July of 2011 was 16,329 MBOE, a whopping 36.9% of the estimated reserve level represented by Chesapeake to potential unit holders when capital was being raised to fund the Trust.
The PV-10 standardized measure per unit as of 12/30/2013 fell to $6.78. This value, when adjusted for depletion for the first 2 quarters of 2014, has fallen to $6.29 as of 6/30/2014. Overall price changes in the PV-10 were more favorable than in 2012 for oil and natural gas, while NGL prices were lower. The 2013 PV-10 report utilized a delivered price level of $2.36 per MBOE for natural gas production, which was an improvement from the $1.60 used in the calculation in 2012. NGL pricing used in the PV-10, on the other hand, was reduced to $31.86 from $33.22 in 2012.
On August 27, 2014 the Trust units traded at a value of $10.96 on the NYSE, 1.74 times the adjusted PV-10.
The current market traded price per unit, in my opinion, is well above any reasonable fair value assessment of the Trust given the impairments to the reserve data and the expected value of the remaining reserves when current and expected market prices are taken into account.
Trust Fair Value Estimation
The PV-10 is a static price level valuation model of proven reserves. To incorporate the value of potential changes in price levels going forward, the gain in value afforded by the subordinate threshold protection as well as the degradation on unit value from the derivative contracts, it is necessary to use a discounted cash flow valuation model. The table below summarizes the assumptions in a model utilized to derive the valuation of a fixed termination date Royalty Trust like CHKR. The assumptions contained in the following table were used to create a fair value estimation of CHKR. The estimate is based on a go forward distribution forecast derived from the expected depletion of remaining proven reserves held by the Trust, expected market prices for oil, gas and NGL products, estimated future Trust expenses and derivative contract exposure.
The model price assumptions are based on the NYMEX forward price curve as of early August 26, 2014 for oil and gas through 2019. Derivative contract impact based on the expected market price levels is modeled separately and deducted from distributable income through 3Q 2015. The out year price levels are grown at a rate of 2.5% annually up to a cap level, which in this model are approached but not reached for any of the products. All prices are adjusted for delivery based on the average differential experienced by the Trust.
The current forward price curve utilized in the model for oil and natural gas is shown in the following two graphs:
The model also uses a product mix as shown in the table, reflecting a downward adjustment in oil mix from the current higher reported levels.
When the price and mix assumptions are combined with the estimated proven reserves remaining at the Trust and the expected production curve, the distributions a unit holder can expect through the end of life of the Trust can be forecasted as shown in the graph below.
Through the August 2014 distribution, the Trust showed depletion of 37.48% of its proven reserves. Total remaining proven reserves are estimated as of June 2014 at 17,153 MBOE. An interesting point for investors to note is that the total cumulative expected remaining distributions to CHKR unit holders is $11.93 using this market model. So in essence, a purchase of units at $10.96 is giving away $11 dollars with the prospect of being paid back $12 over the next 16 years. Even with the Fed zero interest rate policy, 10 year and beyond U.S. Treasuries are paying a much better return, and they are "risk-free".
Based on this model, at the current price level of $10.96 on 8/27/2014 the implied rate of return on the Trust if bought and held to termination is a meager 1.25%. As shown in the graph above (see blue line), as highlighted by Trust management in recent 10-Qs, CHKR is very likely to show rapid declines in unit distributions in the intermediate future even with subordination protection. In addition, once the subordinated units convert, distribution levels can be expected to drop even further. In the model, distributions per unit are expected to fall to $0.25 per unit by the time the subordinate units convert and then continue to drop fairly rapidly through 2017 before a more gradual decline transpires through Trust termination.
Based on the valuation model, if you expect a 10% return on investment, a fair price level for a CHKR common unit is $6.83. This value is very close to the estimated adjusted PV-10 value as of June 2014.
Relative Value Comparison Shows Arbitrage Opportunity
By this stage if you are still reading this report, you can tell that I am not enthusiastic about this investment. Maybe I have caused a stir in investors who own the shares and are looking to rationalize the high price by using different assumptions about the future. I never try to argue with someone else's view about the future, nor do I find it all that useful to try to predict the future in finding investment value.
The primary principle I live by in investing is that all values are derived from relative relationships with other values in the man-made financial universe. In fact, the underlying relative nature of the capital market is one of the driving motivations for my financial opus written in 2013, Theory of Financial Relativity. The book is more a macro review of the relative forces driving the valuation of the overall stock market; however, in one of the early chapters I lay out a fundamental aspect of investment analysis at the micro level which is important to discovering value plays and arbitrage opportunities. The concept is a simple one - you must compare investments of like nature to one another on the same relative scale.
Luckily in the case of CHKR, there is a perfect peer group available for just such a comparison - SDR, PER, and ECT. I have chosen these Trusts because I have thoroughly reviewed each one over the past several weeks, and even published recent reports on each using exactly the same process used to examine CHKR. See SDR Report, PER Report, and ECT Report. In addition, each one is a fixed termination investment which expires at about the same time period in each case.
The table below shows the relative value comparison of each investment. Both the adjusted PV-10 value as wells as the derived fair value estimate of each Trust using the discounted cash flow model utilized in this report are shown in the table.
As you can see in the above table, CHKR with a 1.74 PV-10 multiple versus the peer group range of .92 to 1.34 is a relative outlier, very likely by more than 2 standard deviations in statistical terms.
Given the information contained in this report, if you are a prospective investor in CHKR, you might want to play the short rather than the long side of the trade. My fair value estimate for the units is $7 per unit, which may still be generous pending the results of the remaining 25 wells to be drilled. Further downward revisions appear to be possible, especially given the leadership the Trust has exhibited in this inauspicious category.
Looking at the valuation from a different perspective, I compare the current characteristics of CHKR most closely to that of SDR on a valuation basis. The product mix in both Trust are very similar, with SDR showing a slightly higher oil versus NGL content, but roughly the same liquid content overall. Additionally the well impairments being encountered at each Trust are having similar impacts on the expected future reserve recovery. When all the known and expected impacts are netted, the future distribution stream in each Trust is currently very similar. Systemic market changes like price fluctuations will affect the Trusts in very identical ways, good or bad. In a market sense, there is an arbitrage in place where an investor can swap the 17,153 remaining MBOE at CHKR for the reported 19,088 MBOE remaining at SDR, and net the differential of $4.25 per unit while receiving a very similar income stream going forward. There are risks of course because the two assets are not identical twins. But based on the financial assessment, the market seems to have done a better job pricing in the risk in the SDR units, while going completely off-track with respect to CHKR units.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.