The SandRidge Mississippian Trust I (SDT) was formed by SandRidge Energy (SD) on December 30th, 2010 in an effort to monetize its oil and gas lease and production assets located in the Mississippian formation in Oklahoma. On April 4th, 2011, SandRidge sold 17.25 mln units of SDT at $21.00 per unit in an initial public offering. Following the offering, SandRidge held 3.75 mln common units and 7.00 mln subordinated units, totaling a 38.4% beneficial interest.
Over the past eight months, SandRidge has been aggressive seller of its SDT common units. In fact, on October 2nd, SandRidge sold 688,000 units at $22.98 per unit - a $1.66 per unit discount from the prior day's close of $24.64. Following this transaction, SandRidge holds just 528,000 of its original 3.75 mln common unit position.
The Trust Assets and Distributable Cash
The SandRidge Mississippian Trust I owns perpetual royalty interests in 42,900 net acres of oil and natural gas properties leased by SandRidge in the Mississippian formation in Alfalfa, Garfield, Grant, Major and Woods counties in Oklahoma. The royalty interests entitle SDT to receive 90% of the net proceeds attributable to the 37 horizontal wells in production on the properties prior to the creation of SandRidge Mississippian Trust I and 50% of the proceeds from the 123 horizontal wells expected to be drilled on the properties in the three years following the trust's IPO (these are referred to as the "PUD wells" or the "development wells").
The trust generally receives the percentage of proceeds which it is entitled to under the conveyances (90% for the producing wells and 50% for the development, or PUD wells) multiplied by SandRidge's net revenue interest in the well. On average, SandRidge owns a 56.3% net revenue interest in the producing wells, providing SDT an average 50.7% net interest in the producing wells (90% of 56.3%), and an average 57.0% interest in the properties on which the development wells will be drilled, providing SDR an average 28.5% net interest in the development (PUD) wells (50% of 57.0%).
The trust is not responsible for any drilling, operating or capital costs relating to the development (PUD) wells. The trust is, however, required to pay post-production costs, such as costs to gather, store, compress, process, treat and market its share of the oil and gas produced, as well as applicable taxes.
Incentive Distribution Rights
One of the more interesting reasons to hold oil and gas trusts is that they allow investors to gain exposure to energy prices without facing the structural costs (management fees, futures trading costs and contango-related losses) that lead ETFs such as the United States Natural Gas Fund (UNG) and the United States Oil Fund (USO) to significantly underperform their respective commodity benchmarks. Unfortunately, some trusts, such as the SandRidge Mississippian Trust I, provide their general partner (not you the unit holder) special 'incentives' when distributions increase significantly - even if the increase is the result of commodity price inflation. These incentive programs significantly diminish the potential upside to distributions. In the case of SDT, SandRidge Energy receives 50% of the available cash for distribution in excess of 20% above the designated threshold distribution rate (currently $.735 per quarter).
In return for the incentive distribution rights, the 7.00 mln subordinated units (25% of the total units outstanding) owned by SandRidge Energy will face a reduction (or even elimination) of distributions if necessary to ensure that the common units receive no less than 20% below the designated threshold distribution rate.
The threshold distribution rate ranges between $.73 and $.77 per quarter for the rest of 2012 and all of 2013, before steadily increasing from $.78 for the first quarter of 2014 to $.89 for the fourth quarter of 2014.
Further limiting the potential upside of SDT's distributions, the trust has "hedged 54% of expected production through December 31, 2015." Looking a little deeper into its S-1 and more recent financial statements, we believe that SDT has hedged more than 100% of its expected natural gas production through 2015 (using $4.00/mmbtu to $7.15/mmbtu collars in 2013, $4.00/mmbtu to $7.78/mmbtu collars in 2014 and $4.00/mmbtu to $8.55/mmbtu collars in 2015) and roughly 60% of expected oil production through 2015 at weighted average WTI crude prices ranging between $100.94/bbl and $104.15/bbl.
SandRidge pays SDT any net proceeds received from the settlement of these derivatives, while SDT is required to reimburse SandRidge for any losses realized on the derivatives. In the most recent quarter, 16.05% of the distribution paid to SDT unit holders ($.112 of the $.7277 per unit distributed) was the result of derivative gains.
The Accelerated Development Well Program
While many investors take refuge in the fact that the SandRidge Mississippian Trust I is not scheduled to expire until 2030, based on the current pace of development well drilling, the trust will effectively go into liquidation in May 2013: Once SandRidge fulfills its obligation to drill 123 gross new horizontal wells on the 'Area of Mutual Interest' (AMI) properties, the trust will no longer benefit from the addition of new wells and the existing wells will face sharp production declines. Keep in mind that all of the wells are high decline-rate horizontal wells!
In its S-1, the SandRidge Mississippian Trust I detailed that its planned drilling program would result in the following production profile (based on the continued drilling of development wells continuing through early 2014):
Since the IPO, the development well program has been pulled forward sharply relative to the original plan - possibly because SandRidge was left holding more contracted rigs than its own capital budget required and possibly because SDT's quarterly distributions could have fallen below the threshold that would have required reduced distributions on the subordinated units had drilling not accelerated. Regardless of the reason, the following table shows the historical and projected drilling activity to the credit of SDT:
The acceleration of the development well program means that the 123rd well to be drilled under the program, which will be the last new well to be drilled for the benefit of SDT, will likely be drilled in May 2013. As I mentioned, after the last well is drilled, production (and thus distributions) will decline quickly.
Unfortunately, the threshold (minimum) distribution protection that the subordinated units provide the common units will expire four quarters after SandRidge fulfills its obligation to drill the 123 horizontal development wells for the benefit of SDT. Based on my estimate that the development wells will be completed in May 2013, the subordinated units will become common units in May 2014. Once the subordinated units convert to common units, all units will be treated equally and SandRidge will be able to sell the units as well.
Historical and Projected Production
Because of the high decline rates faced by horizontal wells, the incremental thirteen wells drilled in the first quarter of this year were not sufficient to offset the decline rate on the 90 total wells that had been drilled prior to the beginning of the quarter. If we use the production decline rate guidance implicitly provided in the production forecast for the 37 existing wells in SDT's S-1 (and shown on the 'Net Production to the Trust' graphic above), we can make forward production projections based the provided decline curve and the number of wells drilled by quarter. The historical production data for the past three quarters, as well as our modeled quarterly production estimates through 2019, are shown on the table below:
The projected production profile presented in SDT's S-1 anticipated that total production would increase from approximately 1,300 Mboe in 2012 to 1,390 Mboe in 2013 then peaking at approximately 1,520 Mboe in 2014, before declining to roughly 1,390 Mboe in 2015, 1,100 Mboe in 2016, 950 Mboe in 2017, 815 Mboe in 2018 and 780 Mboe in 2019. Due to the acceleration of the drill program relative to initial plans, however, second quarter production totaled 413 MBoe - an annual rate of 1,652 Mboe. This is significantly above the roughly 1,300 Mboe implied 2012 average production rate based on SDT's 'Net Production to the Trust' graphic and actually above its previously-projected 2014 production peak. The same graphic predicted that total production for the benefit of the trust would decline by 50% over the six years following the end of the development well drilling program (2015 through 2020).
By our calculations, oil and natural gas production for the benefit of SDT will total 1,612 Mboe in 2012, 1,267 Mboe in 2013, 1,036 Mboe in 2014, 910 Mboe in 2015, 849 Mboe in 2016, 811 Mboe in 2017, 780 Mboe in 2018 and 749 Mboe in 2019 - fairly close to a 50% production decline over the six years following the end of the development well drill program. Beyond 2020, we expect production to decline by 3% per year.
The SandRidge Mississippian Trust I already trades at a discount to other trusts (a 12% yield versus 8% to 11% yields), most likely due to the declining distribution profile of the trust. In our calculations, we assume that WTI crude prices average $96/bbl in 2012 and Henry Hub natural gas averages $2.70/mmbtu. We also (quite favorable for SDT) forecast that both commodity prices inflate by 3.6% per year going forward (see our recent article on the BP Prudhoe Bay Trust (BPT). We also forecast that post-production and tax expenses increase by 2.2% (long-term CPI) from the current $2.48/Bbl
Based on our calculations, shown on the table below, SDT's distributions should fall from $2.95 per unit in 2012 to $2.61 per unit in 2013, $2.39 per unit in 2014 and $1.84 per unit in 2015:
Declining Distributions Will Lead to Negative Returns
With SDT units trading near a 12% yield in recent weeks, we can translate our annual distribution forecasts into expected unit prices so we can calculate the estimated total return of holding the units over the next few years. Based on our 2012 total distribution forecast of $2.95 per unit, at a 12% yield, we would expect the units to be trading at $24.54 - pretty much inline with current trading (by definition). If an investor were to buy the units at $24.54 and hold them through 2013, as you can see on the table above, the investor should receive $2.61 in total 2013 distributions - not a bad return, right? Not exactly.
Although a $2.61 per unit distribution can buy nearly three apps on iTunes, if SDT units end 2013 trading at a 12% trailing yield, they would be trading at $21.73 per unit - a decline of $2.81 per unit from the starting price. Factoring in both the expected 2013 distribution and the forecasted 2013 unit price decline, the total expected return of SDT units in 2013 would actually be a loss of $.20 per unit, or just about a 1% loss. Things become worse in 2014, as the expected full-year distribution declines to $2.19 per unit. This should cause SDT's unit price to decrease by $3.53 per unit, to $18.21, based on a 12% trailing yield - more than offsetting the forecasted distribution yet again. In 2015, the situation will be equally ugly as our forecasted total distribution of $1.80 per unit would result in a unit price decline of $3.25 per unit, to $14.96, if a 12% yield is maintained. Simply put, declining distribution (or dividend) streams often lead to negative returns - even when the yield on the security looks attractive when you first purchase it. This is one of the key mechanisms behind many equity 'value traps.' Another key feature of most value traps is a lack of growth, and SDT will meet this criteria in spades!
What about the NPV?
The revenue-based PV-10 forecast, presented in its most recent 10-K, showed that the value of the SandRidge Mississippian Trust I was $508.3 mln, or $18.14 per unit. The units are currently trading roughly 34% above the PV-10 of revenues. This significantly diminishes the only credible argument for holding SDT units at the moment (since upside is limited by the derivatives and the incentive plan): That near-term unit price declines do not matter if the trust is held for a very long time period.
Another metric I am fond of is the number of years until undiscounted distributions from a trust or MLP pay back the original investment. In the case of SDT, it would take 12.8 years to recover the current unit price using our assumptions - not a very attractive payback period in my view!
Additional disclosure: I am short SDT. Both myself and my firm advise clients on royalty trusts and have advised our clients to sell short or avoid units of SDT.