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Independent trader, mostly on the short side
  • Torch Energy Royalty Trust: Buying $1.45 for $5.30 1 comment
    Nov 10, 2011 3:56 PM | about stocks: TRU
    Overview

    Torch Energy Royalty Trust is not your typical energy trust.  In 2008, unitholders of the Trust voted to liquidate the Trust's assets and distribute the proceeds.  Almost four years later, this process is finally underway thanks to the resolution earlier this year of litigation with Constellation Energy.  In September, the Trust commenced an auction process for all the Trust's assets and final bids were due October 19th.  On November 7th, the Trust announced that winning bidders had been selected and final terms were being negotiated.  The sales are expected to close by year-end.

    Price:  $5.30
    Shares Outstanding:  8.6MM
    Market Capitalization:  $46MM
    Cash (6/30/11):  $2.4MM
       Dividend paid subsequent to 6/30:  $1.4MM
       Expected cash flow Q3 & Q4:  $1.5MM
    Cash (12/31/11E):  1.5MM
    Enterprise Value:  $44.5MM

    The Assets

    The Trust holds 95% net profits interest (NYSE:NPI) in proved developed oil and gas properties in Texas, Alabama and Louisiana.  99% of the Trust reserves are natural gas, the pricing of which has been decimated by the shale gas revolution.  The Trust's contracts are structured such that only profits are distributed; if there are losses, they are accumulated and deducted from future profits should they materialize.  The properties under the Trust's NPI are very mature; all are in steep decline and future production can be predicted with a high degree of certainty.  While there is some upside potential from infill drilling on the Trust's acreage, the Trust only receives 20% of any net profits from such wells and infill wells may divert reserves from the Trust's existing wells thereby reducing future distributions to the Trust.  

    The Trust's interests are being auctioned off in two blocks:  Austin Chalk, Cotton Valley, and Chalkley Fields ("Property Sets 1 and 2") and the Robinson's Bend and Maxwell Crossing Fields ("Property Set 3").  The marketing materials for the auctions were filed in an 8K which can be viewed here. 
    http://www.otcmarkets.com/edgar/GetFilingHtml?FilingID=8112975

    I'll examine Property Set 3 first since it is the potential wildcard in the valuation of the Trust.

    Property Set 3 (Robinson's Bend) consists of 14k net acres and 3.8MMCF/D of gas production.  On the surface, this production stream would appear to offer some value.  However, closer inspection reveals that the acreage has consistently lost money.  In Q2 of 2011, Robinson's Bend yielded revenue of $0.95MM but this was overwhelmed by lease operaing expenses and taxes totalling $1.7MM resulting in a very large loss.  Robinson's Bend has been underwater like this for years and has now accumulated a deficit of $9.0MM net to the Trust.  As such, the Trust has recognized no reserves on this acreage and acknowledged that it is unlikely to receive a distribution ever again.  

    As part of the litigation settlement, Constellation Energy was required make a $1MM bid for Robinson's Bend.  The Trust recently announced that Robinson's Bend Production II, LLC (the operator of the acreage) was the winning bidder so they must have bid in excess of $1MM.  However, given the dim prospects for the Trust NPI on this acreage, it is unlikely that the bid exceeds $1MM by any material amount.  Let's be extremely generous and assume they will pay $2MM.  For unitholders this would amount to 23c per share.

    Backing out $2MM for Robinson's Bend and $1.5MM for expected cash at year end, that leaves $42.5MM for the remaining assets of the Trust, Property Sets 1 and 2.  Here is a table summarizing the metrics:



    Valuing this bundle is straightforward.  Based on the pricing curve at the time reserves were calculated, the net present value of these properties is roughly $10 million, a tiny fraction of the Trust's current market cap.  But it gets worse.  Henry Hub gas is only $3.30 now, down 26% year to date.  

    Commodity Futures Price Chart for Natural Gas Cash bit.ly/s2Zjgr

    According to the 10K, reserves at 12/31/10 were valued at $4.48.  If the PV-10 calculation were done today, the PV-10 would be far lower.  But it gets still worse.   The PV-10 is based on reserves at 12/31/10.  Since that time, an entire year of gas has been produced and production will only be lower in every succeeding year.  A true measure of PV-10 would be reduced by this year's production.

    Let's look at a couple additional metrics.  

    $/acre:  $6,239
    This a very large number for depleted, mature gas-producing acreage.

    $/BOE/Day:  $94,139
    Almost $100k per flowing barrel might work for an oil field with high netbacks and developmental upside.  Many oil-weighted Canadian junior E&P companies can be bought for $50k per flowing barrel.  Natural gas, though, trades at an astonishing 80% discount to oil on a BTU basis (Henry Hub $3.30 multiplied by six versus WTI $99) and 99% of the Trust's reserves are natural gas.  Also, it should be emphasized that the Trust receives only 20% of an net profits on infill drilling.  

    Conclusion

    Torch Energy trades at a massive premium to its net asset value.  The auction of its properties is very unlikely to bring in enough cash to cover the current stock price.  Even in an extremely optimistic scenario of $5MM for Robinson's Bend and $20MM for the remaining acreage, the fair value of the Trust is only $3.30 per share.  A more realistic $1MM and $8MM produces a fair value of $1.45 per share.  
    So why is TRU up so much?  Some possible explanations:
    (1)  The float is very small (roughly 2 million shares) and easily manipulated.  
    (2)  The Trust issued a large one-time dividend and some seem to have been fooled by the large yield. http://seekingalpha.com/article/305783-4-solid-stock-ideas-with-20-yields
    (3)  The stock gained some upside momentum and likely attracted momentum buyers.  Last week during the run over $5, bids of over 40,000 shares suddenly appeared.  Prior to this run, volume was averaging only about 33,000 shares per day.  
    (4)  The announcement of the auction results (sans pricing) sparked interest in the shares.

    While a combination of these factors has propelled the share price to new highs, this jump will be short-lived.  The Trust expects to close the property sales by year-end and will undoubtedly release the results.  At that time, it will be clear to all that the purchase of TRU is like buying $1.45 for $5.30.  But even if the market ignores the news, it will be impossible to ignore the winding down of the Trust and distribution of cash which is likely to take place in early 2012.  

    This article is to be used for informational purposes only and does not constitute investment advice. The author expressly disclaims any liability for accidental omissions of information or errors in fact. 



    Disclosure: I am short TRU.
    Themes: Short Ideas Stocks: TRU
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  • jruedi
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    Very helpful. Thank you
    3 Jan 2012, 10:13 PM Reply Like
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