BP Prudhoe Bay Royalty Trust: Most Overvalued or Most Misunderstood? (Part II)

Feb.10.11 | About: BP Prudhoe (BPT)

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The charts below illustrate when Adjusted Chargeable Costs will become greater than the price of oil, at which time the BPT trust will terminate, under each of the three valuation scenarios I used in my analysis. As a reminder, below are the three valuation scenarios:

  • Scenario #1 (“pessimistic”): Low growth in oil prices (2.5% annually) and moderate inflation (4% annually)
  • Scenario #2 (“moderate”): Moderate growth in oil prices (3.5% annually) and low inflation (2.5% annually)
  • Scenario #3 (“optimistic”): High growth in oil prices (5% annually) and low inflation (2.5%)

Pessimistic Scenario

The chart below shows how the rapidly increasing Adjusted Chargeable Costs eat into the amount of money left over for BPT investors. The blue line represents future oil prices, the red line represents Adjusted Chargeable Costs, and the green line, which is the most important line, represents the amount of money per barrel of oil that is left over for BPT investors.

click to enlarge

Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 4.0% annually and an assumed increase in oil prices of 2.5% annually through 2035.

As you can see, Adjusted Chargeable Costs are the enemy of BPT investors. Under the “pessimistic” scenario, the trust would have no money left over to pay investors starting in 2026 (see the green bar in the chart above for the amount per barrel that is left over for investors). Pursuant to its terms, the trust will terminate after paying no distributions (or very low distributions) for two years in a row. Therefore, the trust would therefore terminate at the end of 2027 in my “pessimistic” scenario.

Moderate Scenario

The chart below illustrates the point at which Adjusted Chargeable Costs will surpass the price of a barrel of WTI oil, leaving nothing left for BPT investors, under the “moderate” scenario.

Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 2.5% annually and an assumed increase in oil prices of 3.5% annually through 2037.

The first thing that you probably noticed is that, under the moderate scenario, the trust pays distributions until 2034 (look at the green bar), which is obviously a good thing for BPT investors. However, beginning in 2035 distributions are negative, and the trust would terminate at the end of 2036. The second thing you should notice is that Adjusted Chargeable Costs increase at a rate that is FAR in excess of the increase in oil prices. Ironically, under the moderate scenario the trust stops paying distributions in the same year that oil prices break about $200 per barrel in 2035! This is an extremely important concept for BPT investors to understand — even if oil prices rise a great deal in the future, it does not necessarily mean that BPT investors will reap the rewards from such increases. Buyer beware.

Optimistic Scenario

The chart below illustrates the point at which Adjusted Chargeable Costs will surpass the price of a barrel of WTI oil, leaving nothing left for BPT investors, under the “optimistic” scenario.

Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 2.5% annually and an assumed increase in oil prices of 5.0% annually through 2060.

It is only in the “optimistic” scenario, in which we’ve assumed that oil prices will skyrocket by 5% each and every year, that we finally see the amount left over for BPT investors (the green bar) holding constant. Even the most bullish of oil investors would consider it unlikely that we’ll ever see these oil prices. Notice that the optimistic scenario assumes oil prices will hit $150 per barrel in 10 years and will hit $250 per barrel in 21 years. The odds that actual prices ever hit these assumed levels seems extremely low to me. Regardless, notice that even though oil is skyrocketing in price, the amount per barrel that is left for BPT investors stays relatively constant (the green bar). Think about what this means: Even if oil goes from $200 to $300 in only nine years, BPT investors do not see their distribution increase at all. In other words, all of the gains from increased oil prices are eaten up by increases in Adjusted Chargeable Costs.

Production Taxes

Any amount that is left over after deducting “Adjusted Chargeable Costs” is subject to production taxes levied by the state of Alaska. The actual rate of the tax depends on oil prices, but it can be as high as 50% so these are significant and are reflected in the valuation analysis presented below.

Termination

At some point, the BPT trust will terminate. According to the trust’s governing documents, the trust will terminate when the total annual amount of distributions paid out by the trust is less than $1 million per year for two straight years.

When the trust terminates, Mr. Lewis is correct; it will be “worth zero. Zilch. Nada.” It is a certainty that at some point in the future, the value of each unit of BPT will be $0. However, between now and the time the trust terminates, BPT investors are able to collect lots of large quarterly distributions. And that is the real question: What is the present value of the future distributions that will be paid out by BPT between now and the time that the trust terminates?

Valuation Results

Now that we’ve run through the adjustments I’ve made to reflect higher reserves, lower production declines, a potentially longer life for the trust, and potentially higher (perhaps much higher) future oil prices, and now that we understand Adjusted Chargeable Costs and production taxes, we’ve got everything we need to estimate the fair value for BPT units. I calculated BPT’s approximate value (I will spare you the math) under the following scenarios:

  • Scenario #1 (“pessimistic”): Low growth in oil prices (2.5% annually) and moderate inflation (4% annually)
  • Scenario #2 (“moderate”): Moderate growth in oil prices (3.5% annually) and low inflation (2.5% annually)
  • Scenario #3 (“optimistic”): High growth in oil prices (5% annually) and low inflation (2.5%)

Note that, as previously discussed, all three of my scenarios use WTI oil prices that are significantly higher than the prices Mr. Lewis used when he calculated the per unit value of BPT at $40.85. Under my “pessimistic” scenario, WTI oil prices will break $100 per barrel in 2015 and will be at approximately $130 by 2025. Under my “moderate” scenario, WTI oil prices will break $100 per barrel in 2014 and will be nearly $150 by 2025. Under my “optimistic” scenario, WTI oil prices will break $100 per barrel in 2013 and will be nearly $180 in 2025.

Value of BPT under each scenario

After estimating future production and then deducting “Adjusted Chargeable Costs” and production taxes, I calculated the price at which BPT units would have to be trading in order for an investor to earn a 10% rate of return on his (or her) investment under each of the three scenarios discussed above.

And I was absolutely shocked by the results.

Pessimistic scenario

The chart below illustrates the annual distributions that a BPT investor would receive from now until the termination of the trust under the pessimistic scenario (2.5% annual growth in oil prices, 4% annual inflation):

Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 4.0% annually and an assumed increase in oil prices of 2.5% annually through 2027.

Under the pessimistic scenario, the total distributions paid out between now and the trust’s termination in 2027 would be between $98.66 and $100.25. Remember, though, that you won’t receive most of that money for years down the road. I therefore calculated the price at which BPT units would have to be trading today in order for an investor to earn a 10% rate of return on his (or her) investment. The answer? Between $56.98 and $57.84 per unit. Under the pessimistic scenario, BPT units are currently about 50% overvalued.

Moderate scenario

The chart below illustrates the annual distributions that a BPT investor would receive from now until the termination of the trust under the moderate scenario (3.5% annual growth in oil prices, 2.5% annual inflation):

Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 2.5% annually and an assumed increase in oil prices of 3.5% annually through 2037.

Under the moderate scenario, the total distributions paid out between now and the trust’s termination in 2036 would be between $147.61 and $153.32. Remember, again, that you won’t receive most of that money for years down the road. I therefore calculated the price at which BPT units would have to be trading today in order for an investor to earn a 10% rate of return on his (or her) investment. The answer? Between $69.35 and $70.97 per unit. Under the moderate scenario, BPT units are currently about 38% overvalued.

Optimistic scenario

The chart below illustrates the annual distributions that a BPT investor would receive from now until 2040 under the optimistic scenario (5.0% annual growth in oil prices, 2.5% annual inflation):

Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 2.5% annually and an assumed increase in oil prices of 5.0% annually through 2060.

Under the optimistic scenario, the total distributions paid out between now and the time BP anticipates ceasing production in Prudhoe Bay in 2060 would be between $395.42 and $489.93. It is important to note, though, that you won’t receive much of the distributions for 30, 40, or even 50 years from today. I therefore calculated the price at which BPT units would have to be trading today in order for an investor to earn a 10% rate of return on his (or her) investment. The answer? Between $85.13 and $89.15 per unit. Under the moderate scenario, BPT units are currently about 23% overvalued.

How could this possibly be? As you’ve probably surmised, the limiting factor — the factor that will cause the trust to terminate, at which time the unit price will go to zero – is not reserves. It is not production declines or oil prices. Rather, the culprit is enormous future increases in “Adjusted Chargeable Costs” that are deducted from each barrel of oil produced in the future. These costs are deducted before BPT holders get a single penny in distributions. As these costs increase (and, as we’ve seen, they will increase rapidly), the amount left over to be paid out to BPT holders will quickly diminish until, ultimately, nothing is left. Even worse, the enormous increases in “Adjusted Chargeable Costs” are contractually fixed and therefore cannot be changed, and practically no amount of oil reserves or increases in oil prices will be enough to overcome them.

And so, after reviewing the results that I’ve just shared with you, I reluctantly sold all of my units in BPT. Unfortunately, the reality is that BPT may be overvalued by as much as 50%. Considering the facts that (i) over the coming years the distributions will fall significantly and eventually be $0 and (ii) eventually the unit price will also go to $0, there is just no way to justify the price at which BPT is currently trading (even, as I’ve shown, if oil prices soar to $200 per barrel or higher).

So when will BPT investors realize that this is overvalued (at which time, presumably, the price will correct)? My guess is that many retail investors blindly purchase BPT units because (1) it currently pays a high distribution and (2) they have some belief that oil prices will go up in the future and BPT will allow them to reap the rewards of such increases. After all, if the trust were fairly valued as described above, then it would have an enormous yield well in excess of 10%. This would undoubtedly bring in “dividend hunters” as buyers, pushing the price back up. What these investors fail to realize, however, is that a large portion (or, in the case of the “pessimistic” scenario above, virtually ALL) of the distributions paid by BPT are effectively a return of capital and not a distribution at all.

The bottom line: Would you give someone $114 of your money today if they promised to pay you back a total of $100.25 over the course of the next 15 years (but not the original $114 that you paid to them)? If not, and if you believe the “pessimistic” scenario described above best reflects your view of oil prices and inflation in the future, then you might consider looking for investments other than BPT because that is effectively the “bargain” you’re striking when you buy BPT at today’s prices.

Would you give someone $114 of your money today if they promised to pay you back a total of $153.32 over the course of the next 24 years (but, again, not the original $114 that you paid to them)? If not, and if you believe the “moderate” scenario described above best reflects your view of oil prices and inflation in the future, then you might consider looking for investments other than BPT because that is effectively the “bargain” you’re striking when you buy BPT at today’s prices. The same holds true for the “optimistic” scenario.

Disclosure: I am short BPT. Until January 31, 2011, I owned BPT units in my portfolio. On January 31, 2011, I reviewed the initial results of my analysis, which are discussed in this article. I now own a small number of puts, as I believe, for the reasons stated above, that BPT is likely to decline in value.