Oil Doubles, But BPT Should Still Get Cut In Half

| About: BP Prudhoe (BPT)

Summary

BPT’s price has collapsed despite an extraordinary rally in the price of oil.

We believe that this anomaly is due to the market’s recent recognition that there is a clear line of sight to BPT’s last dividends.

As this becomes more broadly understood, we believe that current yield will become an increasingly irrelevant valuation tool in favor of the net present value of the remaining cash flows.

On this measure, BPT remains significantly overvalued with its current price representing more than twice its fair value.

We expect BPT’s significant underperformance to continue until the shift in PBT’s valuation paradigm is complete.

BP Prudhoe Bay Royalty Trust's (NYSE:BPT) price has collapsed since a bearish investor issued a press release highlighting disclosures from the Trust's 2015 Form 10-K and following our prior article regarding the Trust. In that article, we provided a description of the Trust, its contractually-escalating cost profile and the resulting expected cash flows to the Trust based on the price of oil. Our conclusion was that the fair value of BPT at that time was over 70% below its trading price.

In this article, we reexamine these expected cash flows in the context of oil's extraordinary rally from its low on February 11 th to its current high. We also provide some context for considering future production levels given the news that BP has reduced the number of rigs that it is operating in Prudhoe Bay to 2 from 5. Finally, this article is a response to a report in another forum that suggests that BPT is a bet on the oil price recovering (link). While true, we felt it would be useful to assess just how much of a recovery is required to justify a purchase at BPT's current price.

Oil Price Rally

On February 11 th, the spot price for West Texas Intermediate crude oil ((NYSE:WTI)) closed at $26.21 a price not seen since 2003. It subsequently rallied approximately 68% to over $44 as of April 26, 2016. Despite this rally, BBT has fallen over 40% during this period. Given this incredible underperformance, it would be tempting to believe that BPT is now undervalued. This however is the wrong conclusion as our analysis shows that BPT's underperformance is not the result of an attractive valuation anomaly - rather we believe it is the result of the market coming to recognize that the end is approaching for BPT.

Price of WTI and BPT

Oil Price Scenarios

The graph below shows the forward curve for WTI as of its February 11 th low point and the current high on April 26 th. We have also included the SEC reference price of $50.28 which readers of our first article will recognize as the basis for the Trust's publicly disclosed PV-10 value. We will use these three price scenarios to examine how the fair value of BPT changes with differing oil price expectations.

WTI Forward Curve

Contractual Costs

As we did in our first article, we examine the expected quarterly per barrel costs that are used to calculate the cash flows owed to the Trust. Since the detail of how these contractual cash flows are determined was presented in our first article, we will not repeat it here. We will however remind readers that only two assumptions need to be made. The first is the future rate of inflation associated with the costs charged to the Trust - which we have again assumed to be zero. The second relates to the production taxes which are based on the price of WTI. For the charts below, we have depicted the taxes based on the April 26 th forward price (In our NPV analysts we used the appropriate production tax calculation for each scenario).

Per Barrel Costs Click to enlarge

As a reminder, the contracted costs are not related to the actual costs incurred at Prudhoe Bay. Rather, they are driven by a schedule that was agreed at the time that the Trust was created. They begin to escalate at a rapid pace beginning in 2018 with these increases continuing until the termination of the Trust. The actual cost increase will be greater than depicted above should the actual rate of inflation (based on the CPI) be greater than our assumption of zero.

Per Barrel Cash Flows

In the chart below, we depict the per barrel cash flows earned by the Trust in each of our price scenarios. These values are represented by the difference between the price of WTI in each scenario vs the associated cost for each period.

Per Barrel Royalties Click to enlarge

As shown, the per barrel royalty has improved significantly since the February low of the oil market and, based on the current forward curve, it appears that royalty payments may persist until 2021 rather than 2020. However, it is worth noting that even with the historic rally in the price of oil, the current forward curve is still (on average) below the SEC price for the relevant time period.

Implied Value

To determine the value of BTU's units, we multiply the per barrel royalty by the expected volume of production for each period. We use a 10% discount rate which is consistent with the rate used by the SEC and is a yield that we believe to be fair for the risks associated with the Trust's cash flows. With regard to expected production, at this point in our analysis we have assumed a 1.5% annual decline while considering the seasonality of production at Prudhoe Bay. In accordance with the Trust's royalty agreement, we cap volumes for each period at 90,000 barrels per day.

Based on these assumptions and the assumption that the Trust's future administrative expenses will be consistent with those of the past we calculate the NPV of the expected cash flows of the Trust to be as follows for each of the scenario's considered:

Price Scenario

As shown in this chart, we have also calculated the implied return of the units based on their closing price as of April 26, 2016. Our conclusion at this point in our analysis is that, while the NPV of the Trust has increased by $5.76 since the recent low of the oil market, the units are trading at nearly twice their fair value.

Production

We have based our work thus far on the assumption that the production decline rate would be quite benign for Prudhoe Bay. However with BP's decision to reduce the working rig count from 5 rigs to 2, we believe that it is worthwhile to consider other scenarios. To do so we looked to the data for the Alyeska Pipeline which transports oil produced in Prudhoe Bay and other fields in the Alaska North Slope. This data is available on the pipeline's website and in the graph below we have depicted the average annual volumes since production peaked in the late 1980s.

Alyeska Pipeline Average Daily Volume

The decline rate for the past 10 years has averaged approximately 5.5%. It is worth noting that 2015's average volume of 508 MBbl per day is now at a level which presents real challenges for the pipeline as described on the operator's website. While we have not contemplated what a permanent or temporary loss of the pipeline would mean to the Trust, we have looked at the value of the units should the announced reduction in drilling cause Prudhoe Bay production to decline at the increased rate of 5%.

Price Scenario 2

As expected, the quicker decline in production further reduces the fair value of the units with the NPV based on the current forward curve dropping from $8.36 to $7.77 per unit or less than half of the current price of the units.

Implied Oil Price

In our final analysis for this article, we determined what oil price was required to justify BPT's current price of $16.18. We continued to assume that inflation would be zero while assuming that production would decline at 5% as discussed above. We then used increasingly higher fixed price assumptions for WTI (beginning as of April 1, 2016 and continuing in perpetuity) until the NPV of BPT's cash flows matched the current unit price. As shown below, justifying BPT's current trading price requires a WTI price of nearly $60. Said differently, WTI, having rallied almost $18 from its low, would need to rally nearly $16 more for the current price of BPT to be warranted.

Implied Price of WTI

Conclusion

As we stated in our first article, we believe that BPT is neither a good source of income nor is it an attractive way to express a bullish view on oil. For investors seeking income, buying a royalty trust with a limited remaining life is dangerous game which leaves investors who are slow to leave the party holding the bag (Whiting USA Trust I (WHXT) provides a clear example of how such things end).

For investors seeking to express a bullish view on oil, we ask why anyone would do so with a security that is already implying and immediate and permanent increase in the price of oil to nearly $60. If one is confident that the price of oil will quickly rise to that level, we believe that there are far more attractive and lucrative ways to express that view.

Disclosure: I am/we are short BPT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.