In my recent article here on Seeking Alpha, entitled The BP Prudhoe Bay Royalty Trust: A 9.8% IRR With A 9 Year Payback I presented a NPV valuation scenario which was based on an 8% discount rate, production for the credit of the Trust above 90,000 bbl/d through 2016 (prior to declining by 2% per year), 2.2% annual CPI inflation and 3.6% annual WTI price inflation. The result was a $95.66 per unit NPV, which effectively means that an investment in the units of the BP Prudhoe Bay Royalty Trust (BPT) at $95.66 per unit is expected to provide an 8% annual return over the life of the investment, using the assumptions presented.
Most of the comments on the article centered around the future production expectations and WTI prices over time, leaving me somewhat surprised that nobody made the point that the majority of global oil trades at OPEC Basket/Brent pricing, currently $113.92 per bbl, while WTI prices are currently trading at a $17.45/bbl discount, or at $96.47 per bbl. Over the past twelve months, the average discount of WTI to Brent was $15.31 per bbl.
The WTI Discount to Brent
West Texas Intermediate (WTI) crude is a lighter (and arguably more valuable) crude than Brent, refined mostly in the Midwest and Gulf Coast regions of the United States. WTI is the benchmark crude price for much of the oil production in the United States, including the production from the royalty interests held by BPT. In their most recent 10-K, BPT states:
"The "Per Barrel Royalty" for any day is the WTI Price for the day less the sum of ((i)) Chargeable Costs multiplied by the Cost Adjustment Factor and (ii) Production Taxes.... The "WTI Price" for any trading day is the price (in dollars per barrel) for West Texas intermediate crude oil of standard quality having a specific gravity of 40 API degrees for delivery at Cushing, Oklahoma ("West Texas Intermediate") quoted for that trading day by whichever of The Wall Street Journal, Reuters, or Platts Oilgram Price Report, in that order."
As oil production in Wyoming, as well as North and South Dakota (the Bakken Shale and Williston Basin) increased sharply over the past two years, the official WTI delivery point in Cushing Oklahoma began receiving more crude than could be processed, stored or shipped to other regions, depressing the official WTI Price. The following chart, courtesy of Bloomberg, shows the recent divergence between WTI and Brent Crude prices:
Two major pipeline projects are underway to increase the amount of crude that can be moved out of Cushing, Oklahoma, the official pricing point for WTI, into the Gulf Coast region - allowing the WTI to effectively compete with Brent.
Enbridge is in the process of reversing the direction of their Seaway Pipeline, which currently flows 150,000 bbl/d from Cushing to the Gulf, increasing to 250,000 bbl/d in early 2013. Last month, Keystone began construction of the southern 'Cushing to Gulf Coast' segment of the controversial Keystone XL pipeline - which should begin to carry crude from Cushing to the Gulf Coast region by late 2013. Ultimately the southern section of the Keystone XL pipeline will carry 700,000 bbl/d and can later be expanded.
While these projects will help alleviate the bottleneck at Cushing, refiners on the Gulf Coast are currently set up to process heavier Brent crude, likely keeping WTI at a discount to Brent (refiners need an incentive to switch) for at least two to three years.
The BPT NAV - An Alternative Scenario
In our previous BPT NAV calculations, we found that purchasing units of BPT at $95.66 would result in an expected lifetime (of the Trust) return of 8% per year, based on our assumptions. Those lucky enough to purchase the units at $84.78 would receive an expected 10% annual lifetime (of the Trust) return.
If we run an alternative scenario, where we continue to model that oil and condensate production from the properties on which the Trust receives royalties remains above 90,000 bbl/d through 2016, before declining 2% per year, include 2.2% annual CPI cost inflation, but instead estimate that WTI prices move back inline with Brent prices by 2016 (then increase by 3.6% per year thereafter), we find that at an 8% discount rate, the NPV of BPT units under our assumptions is
$114.62 per unit, as is shown below:
Effectively, if one purchased the units at $114.62, a lifetime (of the Trust) annual return of 8% should be expected, based on our assumptions. If the units were purchased at $99.39, a lifetime (of the Trust) return of 10% per year should be expected, based on our assumptions. At the current unit price of $89, the units appear to offer a lifetime (of the Trust) annual return of 11.8% - a very attractive expected return.
Disclosure: I am long BPT.
Additional disclosure: Both myself and my firm advise clients on royalty trusts and have advised our clients to purchase units of the BP Prudhoe Bay Royalty Trust since early 2009