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Based in Houston, Texas Chesapeake Granite Wash Trust (NYSE:CHKR) scheduled a $468 million IPO with a market capitalization of $960 million at a price range mid-point of $20 for Friday, November 11, 2011. The full IPO calendar for the week of November 7 includes five scheduled IPOs.

CHKR VALUATION SUMMARY

We believe CHKR is a good candidate for both retail and institutional income portfolios. It provides a relatively high dividend, with a targeted 13% yield for 2012 at the price range mid-point of $20.

ABOUT OIL TRUSTS

These trusts often attract investors with their relatively high yields. This makes the shares sensitive to interest rates, as share prices are likely to decline in periods of rising interest rates and rise when interest rates fall.

Royalty trusts in the United States and Canada usually involve oil and gas fields or mines which are at or past their production peak, and will gradually decline in output as well as revenue.

SUMMARY

CHKR is an oil/gas trust limited to the Colony Granite Wash formation in the Northern Texas Panhandle with both producing wells and development wells.

CHKR is sponsored by Chesapeake Energy (NYSE:CHK), which has a $19 billion market capitalization. CHK is a well regarded producer of natural gas and oil and natural gas liquids in the United States. Year-to-date CHK’s stock has increased 9.5% to $29.03 from $26.51. CHK pays a 1.3% dividend.

Two recent dividend paying companies IPO’d last week, the week ended November 4, 2011.

Enduro Royalty Trust (NYSE:NDRO) IPO’d Wednesday, November 2, at $22 and as of November 7 was down 3.6%. NDRO's projected yield is 6.75% and its sponsor is a private equity firm rather than a large operating company like Chesapeake Energy. See our NDRO pre-IPO report here.

Rentech Nitrogen Fertilizer (NYSE:RNF) IPO’d Thursday, November 3, at $20 and was up slightly (+.5%) as of November 7. RNF is compared with CVR Partners (NYSE:UAN) and Terra Nitrogen (NYSE:TNH) in our pre-IPO RNF report here.

Also see our pre-IPOreport for CVR Partners here.

CHKR VALUATION

We believe CHKR is a good candidate for both retail and institutional income portfolios. It provides a relatively high dividend, with a targeted 13% yield for 2012 at the price range mid-point of $20.

Comparing CHKR with the two trust IPOs this year, both from Sandridge Energy (NYSE:SD), a relatively strong parent/sponsor, we find that CHKR’s projected yield of 12.5% for 2012 is higher than that initially estimated for the two oil trusts this year from Sandridge Energy.

The targeted yield estimates as of the date of their respective IPOs were 11% for 2012 for both SandRIdge Mississippian Trust (NYSE:SDT) and for SandRidge Permian Trust (NYSE:PER) – at the pre-IPO price range mid-points of $20.

Both SDT and PER so far have outperformed their targeted distributions. We believe CHKR may also outperform its targeted distributions.

CHKR’s future oil price assumptions are based on NYMEX futures pricing as of October 28, 2011, S-1 page 59. More CHKR metrics available here.

Quarterly, per unit, page 8

Sept '11

Dec '11

March '12

June 12

March '17

June '17

Subordination threshold

$0.43

$0.54

$0.59

$0.61

$0.49

$0.47

Target distribution

$0.54

$0.68

$0.74

$0.76

$0.39

$0.37

Incentive threshold

$0.65

$0.82

$0.89

$0.91

$0.59

$0.50

Annual distribution per unit, page 8

2012

2013

2014

2015

2016

Subordination threshold

$3.13

$3.48

$3.41

$3.18

$2.28

Target distribution

$2.50

$2.78

$2.72

$2.54

$1.83

Incentive threshold

$3.75

$4.19

$4.08

$3.81

$2.74

Target return at price

range mid-point of $20

12.50%

13.90%

13.60%

12.70%

9.15%

Also see our pre-IPO reports: SDT here and PER here.

PER and SDT beat dividend September 2011 expectations outlined in their IPO filings.

Since PER’s IPO, the PER trust beat its dividend expectations by 10% and paid $.72 cents for the September quarter, 10% higher than expected. That’s an annualized yield of 14.4% at $20 per unit. PER priced 10% below its range mid-point of $20 and now is up 11% from the IPO price.

SDT similarly beat IPO yield expectations for the September 2011 quarter, with a dividend of $0.82 per share, or $3.26 annualized, which is an 11.7% annualized yield. SDT priced at range top of $21 and is up 32% from the IPO price.

SDT’s targeted dividend expectation in the final prospectus for its IPO was $.67. (final prospectus, page 51)

BUSINESS

Chesapeake Granite Wash Trust is a Delaware statutory trust formed in June 2011 for royalty interests to be conveyed to the trust by Chesapeake in 60 horizontal wells producing from the Colony Granite Wash play located in Washita County in western Oklahoma, and royalty interests in 122 horizontal development wells to be drilled exclusively in the Colony Granite Wash on properties within an “Area of Mutual Interest,” or “AMI.” The Area of Mutual Interest is limited to only the Colony Granite Wash formation and is depicted by the area identified in the inside front cover of the S-1 where Chesapeake presently holds approximately 45,400 gross acres (28,700 net acres).

The trust units do not represent interests in or obligations of the parent Chesapeake.

ROYALTY INTERESTS

Generally, the percentage of production proceeds to be received by the trust will equal the product of the percentage of proceeds to which the trust is entitled under the terms of the conveyances (90% for the Producing Wells and 50% for the Development Wells) multiplied by Chesapeake’s net revenue interest in the well.

Producing Wells – 47.5% CHK Interest

CHKR will have a 90% royalty interest in the Producing Wells. Chesapeake on average owns a 52.8% net revenue interest in the Producing Wells. Therefore, the trust will have an average 47.5% net revenue interest in the Producing Wells.

Development Wells – 26% CHK interest

CHKR has a 50% royalty interest in the Development Wells. CHK on average owns a 52.0% net revenue interest in the properties on which it expects to drill the Development Wells and based on this net revenue interest, the trust would have an average 26.0% net revenue interest in the Development Wells. (S-1, page 81)

TRUST TERMINATION IN 20 YEARS

Unless the occurrence of certain events cause the trust to dissolve at an earlier date, the trust will dissolve and begin to liquidate on the Termination Date, which is June 30, 2031, and will soon thereafter wind up its affairs and terminate.

At the Termination Date, the Term Royalties will automatically revert to Chesapeake, while the Perpetual Royalties will be sold and the proceeds will be distributed to the unitholders pro rata following the Termination Date, but only after the trust has paid, or made reasonable provision for payment of, all liabilities of the trust. Chesapeake will have a right of first refusal to purchase the Perpetual Royalties retained by the trust at the Termination Date. (S-1, page 46)

COLONY GRANITE WASH

The Colony Granite Wash is a formation encountered at depths between approximately 11,500 feet and 13,000 feet that lies between the top of the Des Moines formation (or top of Colony Granite Wash "A") and the top of the Prue formation. Chesapeake intends to drill, or cause to be drilled, the Development Wells from proved undeveloped (“PUD”) drilling locations in the AMI by June 30, 2015, and is obligated to complete such drilling by June 30, 2016.

As of June 30, 2011, and after giving effect to the conveyance of the PDP Royalty Interest and the Development Royalty Interest to the trust, the total reserves estimated to be attributable to the trust were 44.3 mmboe (47.0% oil and natural gas liquids by volume). This amount includes 18.6 mmboe attributable to the PDP Royalty Interest and 25.7 mmboe attributable to the Development Royalty Interest.

OPERATIONS

Producing Wells

Chesapeake currently operates 94% of the Producing Wells and expects to operate approximately 93% of the Development Wells until the completion of its drilling obligation. Chesapeake will market, or cause to be marketed, the oil, natural gas liquids and natural gas produced from the Underlying Properties.

Development Wells

Pursuant to a development agreement with the trust, Chesapeake intends to drill, or cause to be drilled, 118 Development Wells in the AMI by June 30, 2015 and is obligated to complete such drilling by June 30, 2016. Chesapeake will be credited for drilling one full Development Well if the perforated length of the well is equal to or greater than 3,500 feet and Chesapeake’s net revenue interest in the well is equal to 52.0%.

For wells with a perforated length that is less than 3,500 feet, and for wells in which Chesapeake has a net revenue interest greater than or less than 52.0%, Chesapeake will receive proportionate credit. As a result, Chesapeake may be required to drill more or less than 118 wells in order to fulfill its drilling obligation.

TARGET RETURNS EXPECTED TO DECREASE

Chesapeake has established quarterly target levels of cash distributions to unitholders for the life of the trust.

Target distributions initially increase as Chesapeake completes its drilling obligation and production increases, and over time target distributions decline as a result of the depletion of the reserves in the Underlying Properties. (S-1, page 62)

COMPARING TARGET RETURNS AT $20*

*price range mid-point before IPO

Year

SDT

PER

CHKR

2012

11%

11%

13%

2013

15%

14%

14%

2014

16%

16%

14%

2015

15%

15%

13%

2016

12%

13%

9%

SUBORDINATION

In order to provide support for cash distributions on the common units, Chesapeake has agreed to subordinate 11,687,500 of the trust units it will retain following this offering, which will constitute 25% of the outstanding trust units. The subordinated units will be entitled to receive pro rata distributions from the trust each quarter if and to the extent there is sufficient cash to pay a cash distribution on the common units that is no less than the applicable quarterly subordination threshold.

Subordination termination

The subordinated units will automatically convert into common units on a one-for-one basis and Chesapeake’s right to receive incentive distributions will terminate at the end of the fourth full calendar quarter following Chesapeake’s satisfaction of its drilling obligation to the trust.

Chesapeake currently intends to complete its drilling obligation on or before June 30, 2015, and accordingly, Chesapeake expects the subordinated units will convert into common units on or before June 30, 2016. Chesapeake is obligated to complete its drilling obligation by June 30, 2016, in which event the subordinated units would convert into common units on or before June 30, 2017.

INCENTIVE DISTRIBUTIONS

Incentive Distributions. To the extent that the trust has cash available for distribution in excess of the incentive thresholds during the subordination period, Chesapeake will be entitled to receive 50% of such cash as incentive distributions.

Incentive distributions terminate upon completion of the subordination period.

COMPETITION

Chesapeake is the most active company in the Colony Granite Wash play.

Other operators include publicly-listed companies such as Penn Virginia (NYSE:PVA) ($267mm market cap), Apache Corporation (NYSE:APA) ($39bb market cap), QEP Resources (NYSE:QEP) ($6.6bb market cap), SM Energy (NYSE:SM) ($5.35bb market cap) and Marathon Oil (NYSE:MRO) ($19bb market cap).

Privately-held operators in the same geographical area include Samson Oil and Gas Limited, Chaparral Energy, Inc. and Ward Petroleum Corporation.

USE OF IPO PROCEEDS

IPO proceeds of $467.5mm are allocated to:

  • Underwriting discounts and commissions: $26,881,250
  • Structuring fee paid to Morgan Stanley & Co. LLC and Raymond James & Associates, Inc.: $2,337,500
  • Offering expenses: $2,571,922
  • Partial consideration for the purchase of royalty interests from Chesapeake (the parent): $435,709,328

More CHKR metrics available here.

Source: IPO Preview: Chesapeake Granite Wash Trust