Chesapeake Granite Wash Trust's (NYSE:CHKR) next dividend will correspond to production from December 1st until February 29th, and will be announced most likely in the first week of May, and paid out during the third week of May. Because of the long delay between production and the dividend payout, we may hope to accurately estimate the dividend because the prices are accurately known. However, there is still mystery around the exact volume of oil and natural gas produced during that period.
We can put an upper limit on the volume of oil production based off of this most recent quarter's production. Of course the trust produces more than just oil, it also produces natural gas and natural gas liquid; however, production of each is declining. To see this, observe the production output patterns over the last three quarters in Figure 1. You will notice that a decline in production during this time was also predicted by drilling experts back when the trust was first formed and this prediction influenced both the future dividend estimates, as well as the amount of oil they hedged for each production quarter. Both of these are reported in the 2012 10-K [See Figure 2].
Figure 1: These are excerpts from the 8-K forms from the three most recent dividend payouts. Each shows the total volume of oil, natural gas, and natural gas liquid sold for each period as well as an equivalent oil volume quantity measured in mboe, or thousand barrels of oil equivalent.
Figure 2: Above are two screen shots from pages 7 and 8 respectively of the CHKR 10-K filed in March 2012. The first shows the predicted dividend range given a constant price of oil adjusted for inflation. The second shows the oil hedges they had which were covered on their end by how much oil they could reasonably be expected to produce.
The price of oil from December 1st 2015 to February 29th 2016 has been strictly lower than that of the previous period of September 1st to November 31st; yet, there are two more points to consider about future dividends. The first is that at some point the CHKR's subordinated shares will convert to regular shares reducing the cash dividend to ¾ of what it would be otherwise. Second, the trust has previously been party to lucrative oil hedges established when the trust was formed for exactly the reason of protecting the dividend given a crash in the oil price. In the most recent quarter [see Figure 3], the trust made over half of its distributable income from oil hedges that expired on September 30th, 2015, meaning only the production from August and September, but not November were covered in the most recent dividend that went ex-dividend 2/17/16.
So in the best case that we assume the trust's income from selling oil in the current period matches that from the previous period (which is unlikely because of price and production declines), the total distributable income should be around $3.384 million [Figure 3] which divided by 35.0625 million shares (the non-subordinated ones) would result in a dividend of $0.0965. If it were subordinated, which could start as early as 2017, we would instead divide the profit among 46.75 million shares.
Figure 3: This is an excerpt from the February 2016 Dividend announcement results.
There are two ways in which I would predict quarterly production decline. First, we can observe the predictions for future decline made five years ago in 2011 and excerpted from the 2012 10-K in Figure 2. The estimated production declines can be inferred from the subordination and incentive thresholds reported in the 10-K. Both of these were predicted until 2017 when it was expected the subordination status of the extra shares would expire. The two thresholds actually reflect the same target dividend of which they are a factor of 80 and 120 percent respectively. The purpose of these two thresholds were to punish or reward Chesapeake respectively by changing what percentage of the profits its subordinated units received depending on what the total profit was. If the total profit was not enough to pay at least the lower threshold then all of the profits went only to the unsubordinated shares. These dividend payout estimates were done assuming a constant price of oil adjusted for inflation. Since price was constant across these predictions, the changes in value are a direct estimate of changes in production. Not only did future dividend payouts get tied to these predictions, but they also bought oil hedging contracts for each quarter based on expected production [Figure 2]. Because so much money is or was tied to production estimates, we can expect they were as good as was possible at the time. However, we could be at a different stage of well development than originally expected leading to either larger or smaller declines than expected. Thankfully all of the decline estimates plus or minus a year from today are of equally bad news. From the Q2, 2015 to Q3, 2015 the subordination threshold goes from $0.68 to $0.64 or 6%. Likewise, it moves to $0.56 in Q4, 2015, to $0.51 in Q1, 2016, to $0.47 in Q2, 2016, to $0.44 in Q3, 2016, etc., dropping to as low as $0.37 in Q2, 2017 at about a constant rate of 5% each quarter giving an exponential decay in production. Thus it seems not matter where we are, we should expect a 5% decline in production rate per quarter.
Does this match actual historical results? Looking at Figure 1, we see over the past three quarters in units of mboe (thousand barrels of oil equivalent) that production has gone from 465 to 403 to 349, for a 13% decline each quarter. Additionally, the 13% total decline is split evenly among the three groups of oil, natural gas, and natural gas liquid, with each dropping approximately 13-14% a quarter [Figure 1].
Given a ceiling on the dividend 9.65 cents, we can speculate a 10% production decline and guess the average sale price of the oil and gas produced to see how low the dividend might go. We can calculate a rough value for the average price at which oil and gas were sold at by using a simple moving average with a window of approximately 90 days (or approximately 60 weekdays). I did this on Google Finance using USO (United States Oil Fund) and UNG (United States Natural Gas Fund) 60 trading day window because the ETFs only trade five days a week. Then I compared the ratios of the price on December 1st, to that of February 17th, which we can use to estimate the relative price decline in the Oil Trust's average sale price. The reason for such a roundabout estimate is that is simpler and potentially more accurate since it accounts for relative declines in price without specific consideration to how the Trust's realized price compares to the market price. For USO, the moving average changed from 12.95 on December 1st, to 8.78 on February 17th. For UNG, the price went from 10.82 to 8.05. For oil and gas respectively we should expect the Trust's average sale price to be 68% (8.78/12.95) and 74% (8.05/10.82) of last quarter's prices.
Given last quarter's profit from oil and gas sale of approximately four million after taxes, we can shave off 10% for production decline, and then another 30% for price decline for an expected profit of 2.5 million (4*0.9*0.7) after taxes. We must subtract from this then the estimated quarterly trust expenses [Figure 3], which has historically ranged 0.2 to 0.5 million to get an estimated distributable income of 2.0-2.3 million dollars. Dividing across 35.0625 million shares (the non-subordinated units) would calculate a dividend of $0.0570 to $0.0656. And of course there are still two more weeks of oil drilling for the next dividend which could affect the price.
Before concluding, I would like to disclaim some of my assumptions as well as my current positions in CHKR. I do not know about the Trust's tax situation. According to the November 2015 Q-10 pages 17-18, taxes for that quarter were 2.1% versus 2.4% that same quarter a year ago. However, there was a dramatic price difference in terms of tax per barrel, probably due to the large difference in price of oil from 2014 to 2015. Tax dropped from $0.73 to $0.35 per boe. Thus, the effective tax rate this coming quarter could be 1% rather than the historical 2% given that there will no longer be income from oil hedging contracts. Additionally, I do not understand the mechanism by which oil would be sold the same day it is produced unless it is measured as it comes out of the well and a computer automatically sells it. It could be that the dividend is on an offset of some sort. For example, it could be that the oil sold on December 1st for the coming May dividend was actually drilled a week prior, or of more consequence, that oil drilled on February 29th towards the May dividend will be sold at the price of March 7th. However, whether either of those is the case, or oil is sold as it is drilled, the relative analysis presented here with moving average changes in ETFs such as USO and UNG should be relatively robust to these discrepancies.
Lastly, I would like to disclose that I have a few hundred dollars' worth of short options positions in CHKR, some of which I opened up quite recently (within the past week).
Summary and Conclusions
To conclude, we have calculated a maximum possible dividend for next quarter of $0.0965 by assuming that production has not declined since last quarter, and that price also has not declined. We know for sure that price has declined as the upcoming May dividend will be for production from December 1st, 2015 to February 29th, 2016, most of which has already occurred. Using an estimate of 10% for production decline, and an estimate of a 30% decline in sales profit after taxes and trust fees ranging from $0.2-$0.5 million we can conclude the dividend will likely be between 5.5 and 6.5 cents.
Lastly, I would like to speculate on future dividends. Ever since the third quarter of 2012, the trust's quarterly dividend has been less than or equal to the subordination threshold [Figure 2] for that quarter. Additionally, the current rate of production decline of approximately 12%-14% is anywhere from double to triple the originally estimated production decline of 5%-6%. Even if the price of oil completely rebounds by 2017, the originally estimated subordination dividend for the second quarter of 2017 was only 37 cents. And immediately following this quarter, the dividend will probably be diluted by converting one quarter of the total shares outstanding to regular shares rather than subordinated ones, which means they will start to receive shares of the profit. Thus we have a maximum dividend of approximately 30 cents per quarter. However, production will probably be much lower and prices may remain depressed. I would refer you to another Seeking Alpha contributor Daniel Moore, who as of this writing, has a document from November that attempts to analyze what CHKR's current market value should be where he calculates a figure of 2.30 to 2.80 (After subtracting the most recent dividend). See it on his website here. As a final disclaimer, I have noticed that in his November prediction of future dividends, he expects the dividend to stay above 10 cents until 2017, whereas, given knowledge of the price history over the past few months I expect the dividend to be approximately half of his estimate for this coming quarter and predict that even if prices return to their October and November levels future dividends will remain under 10 cents until at least 2017.
Update as of 3/1/2016 (Article Originally Published 2/23/2016).
In a new (unexpected) SEC filing released just minutes ago, Chesapeake Granite Wash Trust announced it had incorrectly calculated the February dividend, and that instead was only $0.1567 a share rather than $0.2195, but that the company Chesapeake Energy (NYSE:CHK) would forego $1.4 million in distribution from its shares so that remaining shareholders would still receive the original dividend amount. The distribution error resulted from an error in oil hedge payments and had nothing to do with underlying production. This means it does not affect any of the assumptions in the analysis above.
Because I am posting an update, let me say that in predicting May's dividend I assumed that in the remaining days of February, the price of oil would not fluctuate too wildly, and this assumption has played out, and can now be taken as historical data.
Update as of 5/5/2016: Estimate Increase
Disclaimer: As of up this update I still have a short position in CHKR.
Chesapeake Granite Wash Trust should release its quarterly results today as it is the first Thursday of month. We can use new information from the recent quarterly result releases by Sandridge Mississippian Trust II (NYSE:SDR) and Sandridge Mississippian Trust I (NYSE:SDT) to get a better estimate for CHKR's royalty income. This is because all of these trusts have approximately the same rate of production decline, a similar ratio of oil and gas production, and both have experienced similar price declines barring regional differences since all of their quarterly results are from the production period of December 1, 2015 to February 29, 2016.
SDR's royalty income fell from $4.938 to $3.642 million (3.642/4.938=73.75%), and SDT's royalty income fell from $2.504 to $1.898 (1.898/2.504=75.79%). My estimate of approximately 6 cents for the dividend was based on an estimate that royalty revenue would decline to approximately 63% of its value last quarter. However, it looks like it will only fall to 75% of it's last quarter value of $3.959 for a total of $2.969. Subtracting from this expected expenses of $0.2-$0.5 million and dividing by the total number of shares 35.0625 million gives a dividend estimate of approximately $0.07041-$0.07897.
Disclosure: I currently have short positions in CHKR, some of which were opened within the last few weeks. However the total value of these positions is only a few hundred dollars.
Disclosure: I am/we are short CHKR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.