Energy-focused royalty trusts have been under pressure in recent months as falling oil and natural gas prices have depressed distributions at the same time a slew of negative articles have been written about the group. While some of the articles have merit, particularly those discussing the excessive valuation and short expected life of trusts such as Great Northern Iron Ore Properties (GNI), the Hugoton Royalty Trust (HGT) and Whiting USA Trust I (WHX), others, such as the BP Prudhoe Bay Royalty Trust (BPT), have been unfairly punished.
History of the BP Prudhoe Bay Trust
The BP Prudhoe Bay Royalty Trust was created in 1989 when Standard Oil and British Petroleum (BP) conveyed an overriding royalty interest in the Prudhoe Bay field, the largest producing field in North America, located 250 miles north of the arctic circle on the North Slope of Alaska. The Prudhoe Bay Royalty Trust is entitled to receive royalties on 16.4246% of the first 90,000 barrels per day of oil and condensate production from the roughly 45% of the acreage within the Prudhoe Bay field that is subject to the royalty agreement.
The Unit Price Plunge
Between August 27 and 29, the price of BP Prudhoe Bay Royalty Trust units fell from $108.87 to $76.66 - a 29% decline. Following the plunge, I spoke with the trustees as well as a contact at Alyeska Pipeline Service Co, the operator of the Trans-Alaskan pipeline through which oil from Prudhoe Bay flows, and with further research found no fundamental reason for the unit price decline. I believe the price decline was entirely related to the various bearish articles published on BPT over the past few weeks.
The Bearish Thesis on the BP Prudhoe Bay Royalty Trust
The bearish thesis on the BP Prudhoe Bay Royalty Trust is based on four main points:
The first is that oil and condensate production will decline sharply going forward. While production is currently above the 90,000 bbl/d threshold (94,100 bbl/d in Q2), the Trust's SEC filings state that "BP Alaska anticipates that its average net production of oil and condensate allocated to the Trust from proved reserves will be below 90,000 barrels per day on an annual average basis most future years."
The second part of the bearish thesis is that BPT has a dreaded "finite life." In their SEC filings, BPT states " … it is estimated that royalty payments to the Trust will continue through the year 2027. BP Alaska expects continued economic production from the Prudhoe Bay field at a declining rate after that year; however, for the economic conditions and production forecast as of December 31, 2011, the Per Barrel Royalty will be zero following the year 2027." Trust investors HATE to hear that their investment has a finite life - especially after the losses they took on the Great Northern Iron Ore Trust and the Whiting USA Trust I.
The third point is that the trustee estimates that "as of December 31, 2011, production of oil and condensate from the proved reserves allocated to the 1989 Working Interests will result in estimated future net revenues to the Trust of $2,460.5 million, with a present value of $1,433.1 million." This equates to $67 per unit. The NPV calculation is "Based on the 2011 twelve-month average WTI price of $96.19 per barrel" and a 10% discount rate [the rate used since the earliest 10-K].
The fourth and final part of the bearish thesis is that the chargeable production costs incurred by BPT increase by 32% from 2018 to 2020.
Taken together, the bearish thesis on the BP Prudhoe Bay Royalty Trust sounds pretty compelling, until you look at the assumptions.
Future Production Levels
The statement by reserve engineers Miller and Lents that annual production will be below 90,000 barrels per day in "most future years" is not overly damning, considering that BP expects economic production from Prudhoe Bay to continue through 2065 (last published in the 2006 10-K). If we look at the five year production report presented in their most recent 10-K, we see that oil and condensate production for the Trust's working interest declined by 1.8% per year over the past four years - from 91.000 bbl/d in 2007 to 86,200 bbl/d in 2011 (2006 production was 86,400 bbl/d - had 2006 been the start date the five year change in production would have been flat):
Not surprisingly, when oil prices increase, as they did in 2007 and 2008, production from Prudhoe Bay increases. In fact, during the royalty payment quarter ending January 2012, production attributable to BPT's royalty interest was 92,200 bbl/d and in the quarter ending April 2012, production attributable to BPT's royalty interest averaged 94,100 bbl/d. We believe that $96 WTI will lead to further production increases from Prudhoe Bay in 2013 and 2014, and will be very supportive of production levels thereafter - contrary to most of the bearish arguments against BPT.
At the same time, oil and gas companies are beginning to look at Prudhoe Bay with renewed interest now that horizontal drilling technologies are being applied to older fields. In their second quarter conference call, Parker Drilling (PKD) mentioned that they have contracts for two high-end rigs to begin work for BP at Prudhoe Bay by late 2012 or early 2013, joining the roughly 15 (dated) rigs in place. Apache Corp (APA) mentioned on their second quarter call that they are buying acreage in Alaska and moving rigs there to take advantage of oil pockets that were previously uneconomical to produce. Other companies, such as Great Bear Petroleum (private) and Shell (RDS.A) are moving into the region and drilling shale formations in and around the Prudhoe Bay.
It is quite likely that oil and condensate production from BPT's interests in Prudhoe Bay will be above 90,000 bbl/d for a decade or more. In his negative BPT article on Seeking Alpha, Shane Blackmon forecast that production from the Trust's interests will average 84,000 bbl/d in 2012 (he failed to include condensate production of 6,000 bbl/d). As we mentioned, reported second quarter production from the Trust's interest was 94,400 bbl/d. Shane went on to predict that production will decline to 83,000 bbl/d in 2013 and to 80,000 bbl/d by 2016. In reality, we believe that given current production levels and historical decline rates, production should remain above 90,000 bbl/d through at least 2015, even if oil prices were to decline and drilling were to slow.
The Termination of the Trust
Technically, the BP Prudhoe Bay Royalty Trust terminates if holders of 60% of the units vote to terminate the trust or "net revenues from the royalty interest for two successive years are less than $1,000,000 per year (unless the net revenues during the two-year period have been materially and adversely affected by certain extraordinary events)." The anticipated termination date is currently 2027, according to BPT. The expected termination date is calculated based on projected oil production, previously-established chargeable costs, and constant WTI prices. Despite 2027 being a fairly extended anticipated termination date in the world of trusts, we would argue that it is unfair to include cost inflation in the NPV calculation while holding the oil price constant. Based on our calculations presented below, we expect the Trust to continue to pay distributions through 2038. Keep in mind that the reserve reports presented in past the 10Ks highlight that BP expects production from Prudhoe Bay to continue through 2065.
In addition, at the expiration of the Trust, the royalty interest will be sold to BP at the greater of the current unit price or an independently determined fair market value. The holders of the trust will have the option of approving a sale, subject to 60% of the units voting in favor, or seeking an alternative bid. The proceeds from the sale of the interest will be distributed to the holders. Other trusts that have gone through liquidation, such as the Williams Coal Seam Gas Royalty Trust (WTU), have received reasonable valuations for their interests (WTU received $20 mln, or $5,610 per acre). None of the articles claiming that the BP PRudhoe Bay Trust will expire in 15 years include any proceeds for the sale of the Trust's royalty interest in their NPV calculations.
The Trust's NPV Calculation
The NPV calculations provided in BPT's 10-K were performed by an independent firm (Miller and Lents) using production estimates provided by BP. The primary problem with their NPV, as we mentioned, is that the expenses for the trust, predetermined and spelled out in the 10-K, escalate over time while the crude price is held constant. In addition, their NPV is based on a 10% discount rate - the same rate that has been used since at least 1995 - which is a little high for the largest and most liquid U.S. royalty trust in the current interest rate environment. As you can see on the table below, provided in BPT's 2010 10-K, the Trust's NPV is highly variable based on assumptions provided by BP and the changing WTI price:
In 2008, WTI crude ended the year at $43.35/bbl. In 2009, WTI ended the year at $79.76/bbl and in 2010, WTI ended the year at $91.50/bbl. Over these three years, the NPV of BPT nearly tripled, from $19.55 per unit to $55.42 per unit, despite the trust paying out a total of $27.68 per unit from 2008 to 2010. Investors who chose not to buy units of the BP Prudhoe Bay Royalty Trust in the low $70's per unit in early 2008 based on the company-provided December 31, 2008 NPV ($19.55 per unit) would have missed a very strong two year total return.
What is the BP Prudhoe Bay Trust Worth?
So how should we value the units of the BP Prudhoe Bay Royalty Trust? While we agree that an NPV-based valuation approach is useful, the assumptions used in the 10-K calculations and those posting articles online are wrong. We will therefore present our own NAV calculations.
We will begin our NPV calculation with the expense calculations. In their SEC filings, BPT shows that their expenses per barrel of oil and condensate produced are pre-determined:
You can see on the above table that chargeable costs are not only very low, but they do not increase significantly prior to 2018. While some see this as a negative, the resulting long-term cost inflation trend is still fairly reasonable and the hockey stick-shaped chargeable cost curve benefits the Trust's current NAV. Beyond 2020, the chargeable costs per barrel increase at a uniform rate of $2.75 per year.
In addition, the trust expenses incur a 'cost adjustment factor' which is the ratio of the Consumer Price Index published for the most recent February, May, August or November to 121.1 (the CPI in January 1989). The most recent adjustment factor was 1.753, making the total chargeable costs per barrel $29.28 per bbl ($16.70 X 1.753).
BPT is also responsible for Alaskan oil and gas production taxes, which start at 25% of gross profits as long as pre-tax gross profits, or the "production tax value," are above $30 per bbl. In addition, since 2006 oil and gas producers must pay a "progressivity tax" rate of .4% times the average earnings per bbl AFTER the base tax is withheld. In the first quarter, the BPT realized average oil prices of $93.92 per bbl (WTI) and had chargeable production costs of $28.92 per bbl. This resulted in gross margins of $65.00 per barrel. The base tax was thus $16.25 per bbl ($65.00 X 25%), making profits after the base tax $48.75 ($65.00 - $16.25). The progressive tax was thus $9.51 per bbl (.4% X 48.75, or 19.5% of $48.75) - making total taxes $25.76 per bbl ($16.25 + $9.51). The reported production tax was $25.47 per bbl in Q1, with the difference versus our calculation likely due to rounding. If after-tax gross profits exceed $92.50 per bbl, equating to roughly $122 per bbl WTI crude for the current expenses of BPT, the progressivity tax quickly increases to a 50% tax on gross margins - the ceiling tax rate by law - due to an additional .1% tax for each $1 WTI is above $92.50. In addition, the base tax has a floor of 10% of gross revenue, subject to the 50% of gross margins ceiling. Many of the NPVs we have seen online, including Shane's, predict future tax rates in excess of 50% of gross profits - contrary to the current tax code.
For our chargeable cost calculations, we will used the chargeable costs as spelled out by the trust agreement and the five year average CPI growth rate of 2.2% (the ten year rate is 2.5%, but we would argue inflation will be somewhat muted going forward).
On the revenue side, we forecast that Prudhoe Bay production will be above the 90,000 bbl/d royalty cap through 2016, then decline by 2% per year thereafter - based on the our view of the impact of recent drilling activity and the long-term decline rate provided by BPT in past (2006 and prior) 10-K's. As we mentioned previously, there is a strong argument that production will remain above 90,000 bbl/d beyond 2016 given the initial success of horizontal drilling in Alaska, but for the sake of conservatism we will assume production declines.
The last variable is the WTI crude price. While the Seeking Alpha articles and the NPVs provided in BPT's 10-K use the most recent year-ending or full year average WTI crude price into perpetuity for revenue calculations, we will use an inflation factor on long-term WTI crude prices. At the very least, one would expect oil prices to keep pace with the annual increase in CPI, which we estimate to be 2.2% going forward. If we look back at historical oil price inflation using data from inflationdata.com, we find that over the past five years WTI crude prices increased by 8.4% per year (from $58.30/bbl to $87.04/bbl) and over the past ten years, WTI crude prices increased by 14.3% per year. In fact, the thirty year annual inflation rate, the lowest of the ten year, twenty year, thirty year, forty year and fifty year inflation rates, was 5.0% per year (the fifty year rate, for those that are curious, was 7.1% - ahead of the fifty year annual increase in CPI of 4.2%).
Another proxy for long-term oil prices are the current profit margins and expected production cost inflation faced by major oil producers. When marginal oil production costs are near the current oil price, as they are today, the oil price downside is limited and the upside will be driven by input cost inflation as production only grows when margins are sufficiently positive. Despite oil prices in the mid-$90's in 2011, Exxon Mobile (XOM) realized gross margins of just 14.77%, Chevron (CVX) realized gross margins of 18.56% and Total (TOT) had gross margins of 12.87%. Production cost inflation, which we believe will also run ahead of CPI, should support oil prices in the near future. For our BPT NPV calculation, we will use an average of the five year CPI inflation rate (2.2%) and the thirty year oil price inflation rate (5.0%), or 3.6% We could have used the thirty year CPI rate (3.0%) to match time periods, but we believe that near-term inflation rates are likely to remain below average.
Based on our assumptions (2.2% annual CPI inflation, 3.6% annual oil price inflation and an 8% discount rate), the NAV of BPT is $95.66 per unit, as can be seen on the following table:
NPVs are Somewhat Misunderstood
Most equity investors look at NPV's backwards, viewing them as providing hard valuations for assets and investments rather than the yield an investment is expected to return at a given price. It is much more beneficial to think of NPVs as the price at which an investment provides the return specified by the discount rate used to calculate the NPV. Effectively, our $95 NPV means is that an investor purchasing BPT at $95 per unit is expected to earn an average annual return of 8% over the life of the investment. In order to earn a 10% expected annual lifetime (of the trust) return, based on our oil price, production and inflation assumptions, an investor should pay $84.78 per unit. Conversely, an investor looking for a 6% expected annual lifetime return, using our assumptions, would be willing to pay $108.92 for BPT units. This approach is similar to how bond investors evaluate various bonds - focusing on the yield to maturity rather than the current price or NPV.
While our NPV calculations show that units of the BP Prudhoe Bay Royalty Trust offer an attractive expected annual return at the current unit price (currently 9.8%), we should also highlight that the expected payback of an investment in BPT today is significantly faster than for almost any other trust. An investor purchasing BPT units at the current $86 unit price will recover 50% of their initial investment from distributions in just under four and a half years, while just under nine years of distributions should pay back the current unit price. This compares quite favorably to other trusts, where distributions are not likely to pay back the their current unit prices for 12 to 15 years, if at all. The fast payback of an investment in BPT units significantly reduces the risk of owning the units, making them even more attractive that a simple NPV calculation implies.