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James Duade
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I started investing several years ago after being Inspired by the works of Benjamin Graham and the shareholder letters of Warren Buffett. My investment ideas are generally guided by Mr. Graham's margin of safety principle, and are adapted to a variety of different market sectors.
  • Treasure Island Royalty Trust: A Fortune Buried Under the Sea 25 comments
    Dec 5, 2010 4:10 PM | about stocks: MMR, EXXI, XOM, BP, TISDZ
    Overview
     
    The Treasure Island Royalty Trust is owed an interest in any production of hydrocarbons that occurs on several blocks of land in the shallow waters of the Gulf of Mexico. The trust trades on the pink sheets and has been largely overlooked since it’s creation in 2002. To date no oil or natural gas production has occurred on the land, and two recent failed drilling attempts by BP and Exxon have kept interest in the trust to a minimum.  However, recent events have created a reason to be optimistic. The legendary geologist and CEO Jim Bob Moffett of McMoran Exploration has reentered the well bores of Exxon, and has reportedly found massive amounts of natural gas deposits where Exxon and BP have found none. Jim Bob has teamed up with Energy XXI Corporation’s John Schiller, and the two have created an ambitious plan to drill other locations on the shelf, and have reportedly found upwards of 100 trillion cubic feet of recoverable natural gas. If the two can extract that amount over the next ten years then the trust would potentially pay out over $50 in royalty income per share. Not bad considering the current price of around $1.70. 
                This somewhat lengthy article aims to bring clarity on why this royalty trust is of interest. An attempt is made to give a background on the geological significance of the Gulf of Mexico shelf, and the sordid history of the trust. Furthermore, several explanations are given on how to value the trust using a variety of assumptions. Lastly, an explanation of how to apply Benjamin Graham’s margin of safety principle to the Treasure Island trust is discussed. 
                This article is purposefully long and detailed so as to give a granular perspective on what may be perceived as an opaque and therefore risky investment. It is my hope that readers will take away a perspective both the great risks and rewards of owning this particular trust. I also, hope that investors will come away with knowledge of whether or not this particular investment is appropriate for their portfolio. Enjoy, and please leave comments!
     
    Background
     
    For millions and millions of years biota from the far flung out posts of the Mississippi River basin has been carried down the massive river to its terminus in Louisiana. The decayed bio-matter is then deposited into the shallow waters running into the shelf of the Gulf of Mexico. Additionally, the carbon rich sediment from the Rockies and Appalachian mountains has also been shed and run off into the Mississippi River Basin (see figure 1), eventually finding its way to the shelf. Over the millennia these deposits have been pushed down by geological events and sedimentation squeezing these carbons together till they are smushed into what is known as hydrocarbons in the form of natural gas, coal, and crude oil. For this reason the Gulf of Mexico has been the focus of oil producers since the early 1900’s. Many of the easy to find oil fields have been drilled and have forced producers to seek oil fields further out in the gulf in order to get at these rich hydrocarbon deposits.
     
    Mississippi River Drainage Basin
                             http://www.oceandoctor.org/wp-content/uploads/2010/06/mississippi-river-drainage-gulf-of-mexico.jpg
                              Fig.1 (From Oceandoctor.org Website, as of 12/3/2010)
               
    An interesting geological feature on the Gulf of Mexico shelf is what’s known as a salt weld, which has also been referred to as a “dancing dragon” (see figure 2). The shelf is typified by shallow water depths that are extremely rich in hydrocarbon deposits. The dancing dragon is a thick line of salt that separates the upper and middle Miocene periods at a depth of 18-24,000 feet. The salt weld is a thick brecciated halite, which essentially means that it’s a layer of rock salt formed during a period when the water on the shelf was low enough to be evaporated. This piece of geology may seem trivial, but it’s anything but. The salt weld acts as a lid that traps oil and gas, and prevents the hydrocarbons from seeping upwards. While the areas above the weld have been mostly tapped by previous oil and gas wells, the area below the weld has never been tapped because of the difficulty and cost involved in drilling below the weld.
     
    History of the Trust
     
    In November, 2002 the acquisition of EEX Corporation by Newfield Exploration created a spinoff company called the Treasure Island Royalty Trust.   The trust was created in order to allow EEX share holders a chance to receive an interest in EEX’s exploration concept on the shelf of the Gulf of Mexico. You can find the original 2002 prospectus at the following link:  http://www.dailyfinance.com/company/treasure-islnd-rty-tr-uts/tisdz/nao/PROSP/02787527/pdf/sec-filings
    The concept, referred to as “Treasure Island” targets ultra deep prospects in the shallow waters on the Gulf beneath the Dancing Dragon of the salt weld. The Treasure Island area covers a large number of lease blocks spread out over a roughly 200 mile stretch of the Louisiana coastline. The blocks are located in the South Timbalier, Ship Shoal, South Marsh Island, and Eugene Island areas. Colorful names from Robert Louis Stevenson’s Treasure Island were given to the blocks, names include:  Captain Kidd, Black Beard West and Black Beard East, Morgan, Dawson, Bellamy, Barataria, and Lafitte. The most relevant blocks to the trust are Black Beard East (block 144), Black Beard West (blocks 168 and 167), and Lafitte (blocks 222 and 223).   
     
    McMoran Drilling Interests including Black Beard Wells & Lafitte Well
    (Purple Structure is Salt Weld)
    http://www.offshore-mag.com/etc/medialib/new-lib/offshore/print-articles/2010/oct.Par.1864.Image.600.315.1.gif
    Fig. 2 (Slide 12 from McMoran Explorations October, 18th 2010 Conference Call)
     
                At the time of the spinoff, the trust was created with 42,574,298 units. The Treasure Island Royalty Trust (OTC:TISDZ) according to the 2002 prospectus is to receive an overriding royalty interest of 1.25% on all production of hydrocarbons produced on trust lands. Because of the difficulty in drilling the depths required to get below the salt weld, Newfield originally teamed up with BP in order to survey and drill the blocks that they felt were most promising. By the summer of 2003 BP gave up, and the trust floundered for a couple of years. In 2005 Exxon came along, and attempted to succeed where BP failed. Exxon drilled a well at Black Beard West, and went below the salt weld to a depth of 30,670 feet. The immense pressure and heat experienced at 30,000 feet forced Exxon to call it quits. No oil or gas deposits were found at the time, and again the trust languished until another suitor emerged with an interest in the area.
                In the summer of 2007, prospecting legend James Moffett stepped into the picture. Moffett, who likes to go by Jim Bob, was 69 at the time and had been a former CEO and Chairman of Freeport McMoran Copper and Gold. Jim Bob had grown up in Texas, and received his undergraduate degree in geology from the University of Texas, and his masters in geology from Tulane University in Louisiana. After his education he went on to co-found McMoran Oil & Gas in 1969 and grew McMoran to be one of the leading oil and gas companies in the United States. In 1981 Jim Bob merged McMoran with Freeport Minerals to create what is known today as Freeport McMoran. After leading Freeport McMoran as Chairman and CEO for a period of 13 years, Jim Bob got back into the oil and gas business with the 1998 spin off of McMoran Explorations. 
                For a 9 year stretch McMoran Explorations didn’t really make any moves of note, everything changed when Jim Bob heard that Exxon was vacating its well bore in Treasure Island. In June of 2007 Jim Bob called up long time friend John Schiller, CEO of Energy XXI, to discuss Exxon’s failure (for a more detailed discussion please read the recent Forbes article written about Energy XXI http://www.forbes.com/forbes/2010/1206/features-bp-john-schiller-energy-xxi-mexico-deep-man.html ). When they hung up the phone the two had engineered a plan to purchase Newfield’s operating interest in Treasure Island for a sum of $1.1 Billion.  Jim Bob had convinced Schiller that Exxon didn’t go deep enough.  The two bet big, essentially leveraging their reputations and their companies on the fact that they could succeed where Exxon had failed. The hope was that an ocean of untapped natural gas and oil existed beneath the salt weld. 
                In order to succeed they contracted a bigger drill rig with heavier equipment and reentered Exxon’s well bore in May of 2008. By October the well was drilled to 33,000 feet and it was clear that they had hit the pay zone of natural gas that eluded Exxon. The drill pipe had reached the mid Miocene shelf sands, and the prize waiting for them was several Trillion Cubic Feet of Natural Gas. Since the find the two have been exploring the Treasure Island properties, and buying up the production rights to any shelf blocks they can get their hands on. 
                Recent drilling by Energy XXI and McMoran Explorations has focused on several areas on the Gulf Shelf, and both companies have been successful in proving that ultra deep drilling can be productive and very profitable. Germane to the Treasure Island Royalty Trust are three exploration wells located at Black Beard West (Blocks 167 and 168), Black Beard East (Block 144), and at Lafitte (Blocks 222 and 223). In recent investor presentations conducted this past October, the two companies gave updates on these wells, and projections as to what they could potentially produce. Projection of recoverable reserves for wells on Trust lands exceeded 60 Trillion Cubic Feet of Gas (see figure 3), and had the potential for Oil in addition to the natural gas discoveries. Later on in this article I will give a detailed evaluation of how to value these prospects using conservative, pessimistic, and optimistic outcomes for the trust. I also urge readers to consult the recent presentations I’m referencing. 
     
    You can find Energy XXI’s recent presentation at this link:http://files.shareholder.com/downloads/EXXI/168499844x0x171511/b8042dba-f903-4549-8c00-b23609f7423b/EXXI_Presentation.pdf for information related to wells on trust lands please review slides 20, 25, 26, 27, and 28. 
     
    You can find McMoran Exploration’s recent presentation at this link:http://www.mcmoran.com/presentatn/2010/3Q10_OCT10.pdf for information related to wells on trust lands please review slides 12, 16, 17, 18, 19.
     
    Estimated Recoverable Natural Gas Reserves
    Including Lafitte and Black Beard East & West
    http://www.energyxxi.com/assets/images/explorationMap.jpg
    Fig. 3 (From Energy XXI’s Exploration Webpage, as of 12/3/2010)
     
    Black Beard West Prospects
     
    The Black Beard West site was first drilled by Exxon in 2005, and was drilled down to 30,000 feet before a combination of heat and pressure forced the company to stop their drilling efforts. In 2007, a determined Jim Bob Moffett came in with John Schiller and drilled down to 33,000 feet to find the pay zone that had eluded Exxon. Black Beard West lays in blocks 168 and 167 respectively, and is about 9 miles West of Black Beard East. Treasure Island owns an interest in production from both blocks.  Treasure Island’s block 168 is the site of the current well, and it has several pay zones in the lower Miocene. It should be noted that Black Beard West’s pay zones are deeper than Black Beard East. The additional depth means that the Black Beard West is slightly more difficult to drill for McMoran, and is very likely to only contain natural gas, and no crude oil. 
     
    Black Beard East Prospects
     
    Black Beard East is located on Block 144 and Block 165; the trust only has an interest in the production occurring on Block 144. All drilling thus far has occurred on Block 144, but there is potential for drilling and extraction of hydro carbons on 165 in the distant future. Black Beard East is located in 80 feet of water, and was spud in the spring of 2010. According to McMoran’s investor presentation in October, well targets should present themselves at a shallower depth than at Black Beard West. Additionally, Jim Bob has spoken very positively in regard to the porosity of the sand at these depths—which generally indicates a good chance that crude oil could be found in this block. So far 5 or 6 zones at Black Beard East have been found to have hydrocarbons below the salt, as of McMoran’s December 2nd press release the drill was at 29,000 feet, and is expected to move down to 30-35,000 feet. The drill is currently moving at a rate of 300 feet a day. Furthermore, Jim Bob expects that the shallow reserves at Black Beard East will be producing in the next 12 to 18 months (this time frame is from Mid October, 2010). Additionally, it should be noted that because of Black Beard East’s lower pressures and temperatures, it is thought that the well may contain several pockets of crude oil.
     
    Lafitte Prospects
     
    This past October, the well was spud in 140 feet of water.  Lafitte is being drilled on blocks 223 and 244, both of which Treasure Island have an interest in. As of McMoran’s most recent press release on December, 2nd the well had been drilled down to around 9,700 feet.  The drill is moving down around 100 or so feet a day, and will hit the salt weld at around 22,000 feet. According to McMoran, the well should go to about 30,000 feet. Both McMoran and EXXI expect to see pay zones of natural gas around 22-30,000 feet or in the Middle & Lower Miocene periods respectively. Please see figure 4 which illustrates the pay zones and drill depth for the Lafitte and Blackbeard wells. 
     
     
    Lafitte, Black Beard West and Black Beard East Cross Sections 
    http://www.faqs.org/sec-filings/100225/PLAINS-EXPLORATION-and-PRODUCTION-CO_8-K/g89985exas23gbgd.jpg
    Fig. 4 (From Plains Exploration and Production May, 26 2010 Presentation at the UBS Global Oil and Gas conference)

    Valuation Assumptions
     
    When creating a valuation, assumptions need to be made in order to calculate future revenue and earnings. In the case of Treasure Island I used several assumptions when valuing the trust’s potential. The first being the amount of reserves located on property lands. The second being the composition of the hydrocarbons found (e.g., ratio of natural gas to crude oil). The third being the number of wells accessing those reserves, which tells you how much natural gas and oil can be recovered in a given quarter or year. The fourth being the price of natural gas and oil during the period the gas and oil are recovered. Fifth, assumptions were made about weather (e.g., hurricanes) potentially interrupting production. Lastly, an assumption was made as to how much general and administrative costs will eat into the royalties generated by the property. 
                The assumptions made were mainly created by using numbers provided by Energy XXI and McMoran in their recent conference calls. As better data is made available, these assumptions will need to be adjusted to account for potential changes in reserves, hydrocarbon rations, and the like. For both the conservative and pessimistic valuations it was assumed that no crude oil would be found and only natural gas would be recovered on trust lands. For the optimistic assumption, a leap of faith was taken in assuming that the recent geological data presented for Black Beard East was indicative of potential oil reserves on the order of 200 million barrels. It is also assumed that both McMoran and Energy XXI will create and maintain sufficient wells to recover the oil and gas reserves at these locations in a timely manner. The period of recovery was assumed to be 10 years (2011-2021), as many natural gas fields can be explored, drilled, and produced in a 10 year span. As for the price of natural gas and crude oil, it was assumed (and conservatively so) that little or no inflation would occur in the respective commodities. It was also assumed that general weather interruptions would occur to the trust during this period, but that no material adverse changes would occur to the trust as a function of weather or a fat tail event (e.g., rig destroyed by hurricane, terrorism attack, etc.). Lastly, it was assumed that the trust would only distribute 80% of its income, and use the remaining 20% for trust expenses. 
     
    Conservative Valuation
     
    As stated earlier, during a recent Energy XXI investor presentation, John Schiller presented a slide that indicated there was upwards 60 trillion cubic feet of recoverable natural gas deposits on Treasure Island Properties.  The deposits were split up as 25 Trillion Cubic Feet at the Lafitte well, and 35 Trillion Cubic Feet at the Black Beard East and West wells.  If one is to believe these estimates, than an investor can come up with a fairly good conceptualization of the value of the Treasure Island units.  The assumptions that need to be made are that the reserves are 60 trillion cubic feet, and that the price of natural gas is $4 an Mcf. This valuation assumes that natural gas will actually lose value from its current market value of around $4.30, and also assumes that no oil will be found at these locations.  Lastly, it is assumed that the natural gas will be extracted over the next 10 years, which is consistent with industry standards in natural gas extraction.  In this scenario the math works like this:
     
    Natural Gas Royalties
    60,000,000,000 Tcf x $4 an Mcf = $240,000,000,000
    $240,000,000,000 x .0125 over riding trust royalty = $3,000,000,000
    $3,000,000,000 / 42,598,724 trust units =  $70.42 per unit.
    Royalty Interest – Administrative costs = $70.42 x 80% = $56.34
    Net Royalty Interest – Investment basis of $1.70 per share= $54.64
    Net Royalty Interest spread over a 10 year period = $5.46 in distributions per year
    % Return in distributions per year verse current share price of $1.70= 311.3%
    % Return on Current 10 Year Treasury Note= 2.75%
    Present Value of Units (assuming investors value TISDZ yield at 10%) = $21.06
     
    Pessimistic Valuation
     
    An investor may choose to discount the Lafitte well prospects since they have not been proven yet, and decide to focus his attention on the Black Beard East and Black Beard West wells instead.  This winnows down the reserves to 35 Trillion Cubic Feet right off the bat.  Furthermore, an investor may also note that Black Beard East is located on two blocks of land, lot 144 and lot 165, and the trust only owns an interest in lot 144.  The proven reserves at Black Beard East fall 40% on lot 144, which is owned by the trust, and the other 60% falls on lot 165 which is not owned by the trust.  This further reduces the trust reserves to 14 trillion cubic feet.  In this valuation we will keep the time frame for extraction at 10 years, and also keep the price of natural gas at $4, which again is a discount to its current spot price of around $4.30.
     
    Natural Gas Royalties
    14,000,000,000 Tcf x $4 an Mcf = $56,000,000,000
    $56,000,000,000 x .0125% over riding trust royalty=   $700,000,000
    $700,000,000 / 42,598,724 trust units = $16.43 per unit
    Royalty Interest – Administrative Costs= $16.43 x 80% = $13.15
    Net Royalty Interest – Investment basis of $1.70 per share= $11.45
    Net Royalty Interest spread over a 10 year period= $1.14 per year
    % Return per year verse current share price of $1.70= 67.1%
    % Return on Current 10 Year Treasury Note= 2.75%
     Present Value of Units (assuming investors value TISDZ yield at 10%) = $4.35
     
    Optimistic Valuation
     
    If an optimistic treatment is given to the data, then we will assume that the 60 trillion cubic feet can all be recovered from trust lands. We will assume that since McMoran and Energy XXI have discussed Lafitte as being a sister well of Black Beard East, because of its comparable structure, that the 25 trillion cubic feet of natural gas can all be recoverable.  Also, since lot 165 has yet to have a well set up, it is assumed that all drilling will be conducted from lot 144 where McMoran and Energy XXI have spent several hundred million dollars of investment attempting to prove the reserves of Black Beard East.  Furthermore, since Black Beard East has lower temperatures and pressures in the pay zone beneath the salt weld, this valuation assumes that some crude oil can be recovered from this location to the tune of 200 million barrels of oil.  Lastly, it is assumed that prices for natural gas and oil will appreciate over the next decade, so that an average well head price for an Mcf of natural gas is $5, and an average well head price for a barrel of crude oil is $90.   
     
    Natural Gas Royalties
    60,000,000,000 Mcf x $5 an Mcf = $300,000,000,000
    $300,000,000,000 x .0125 over riding trust royalty = $3,750,000,000
    $3,750,000,000 / 42,598,724 trust units =  $88.03 per unit.
    Oil Royalties
    200,000,000 Barrels x $90 a barrel = $18,000,000,000
    $18,000,000,000 x .0125 over riding trust royalty=  $225,000,000
    $225,000,000 / 42,598,724 trust units = $5.28 per unit
    Total Royalties
    Total Nat Gas Royalties + Oil Royalties= $93.31 per unit
    Royalty Interest – 20% Administrative Cost= $93.31 x 80%= $74.64
    Net Royalty Interest – Investment basis of $1.70 per share= $72.94
    Net Royalty Interest spread over a 10 year period = $7.29 in distributions per year
    % Return per year verse current share price of $1.70= 428.8%
    % Return on Current 10 Year Treasury Note= 2.75%
    Present Value of Units (assuming investors value TISDZ yield at 10%) = $28.12
     
    Net Present Value of Trust
     
    Lastly, an analysis of the Net Present Value (NYSE:NPV) of the trust was conducted. Two NPV tables were constructed (please see table 1 and table 2 below); one assumes that natural gas prices will fall to an average of $4 from their current spot price of $4.30, the other assumes that prices will rise to $5. At a price of $4, each TCF of Natural gas will result in a royalty interest of approximately $.94 per unit, and an average NPV of approximately $.58 and $.36 if the gas is recovered in a 5 year or 10 year period respectively.  If natural gas is sold at $5, than each TCF of natural gas should result in a royalty interest of approximately $1.18 per TCF, and an average NPV of approximately $.73 and $.45 if the gas is recovered in a 5 year or 10 year period respectively.  
    If we look at the NPV matrices, we can figure out approximately how the market is valuing the trust.  With a current unit price of around $1.70, the market is saying that Treasure Island is only expected to produce 3-5 TCF of gas over a 5-10 year period with a natural gas price of $4.  With a natural gas price of $5, the market is saying that the trust will only produce approximately 2-4 TCF of natural gas.  Given that our pessimistic valuation predicts that 14 TCF will be recovered, it can be assumed that the trust is significantly undervalued by the market.
               
     
    Net Present Value Matrices
     
    Net Present Value Matrix for TISDZ with $4 Natural Gas
    Trillion Cubic Feet
    Nat Gas Price
    ORRI
    Admin. Costs
    Net Royalty Interest Per Unit (after admin. costs)
    NPV if NG is recovered in 5 years
    NPV if NG is Recovered in 10 years
    1 TCF
    $4
    1.25%
    20%
    $0.94
    $0.58
    $0.36
    2 TCF
    $4
    1.25%
    20%
    $1.88
    $1.17
    $0.72
    3 TCF
    $4
    1.25%
    20%
    $2.82
    $1.75
    $1.09
    4TCF
    $4
    1.25%
    20%
    $3.76
    $2.33
    $1.45
    5 TCF
    $4
    1.25%
    20%
    $4.69
    $2.91
    $1.81
    10 TCF
    $4
    1.25%
    20%
    $9.39
    $5.83
    $3.62
    14 TCF
    $4
    1.25%
    20%
    $13.15
    $8.17
    $5.06
    20 TCF
    $4
    1.25%
    20%
    $18.78
    $11.66
    $7.24
    30 TCF
    $4
    1.25%
    20%
    $28.17
    $17.49
    $10.86
    40 TCF
    $4
    1.25%
    20%
    $37.56
    $23.32
    $14.48
    50 TCF
    $4
    1.25%
    20%
    $46.95
    $29.15
    $18.10
    60 TCF
    $4
    1.25%
    20%
    $56.34
    $34.98
    $21.72
    Table 1
    ·         Net Royalty Interest Calculated with 42,598,724 Trust Units
    ·         Net Present Value calculated assuming a rate of return of 10%
     
    Net Present Value Matrix for TISDZ with $5 Natural Gas
    Trillion Cubic Feet
    Nat Gas Price
    ORRI
    Admin. Costs
    Net Royalty Interest Per Unit (after admin. costs)
    NPV if NG is recovered in 5 years
    NPV if NG is Recovered in 10 years
    1 TCF
    $5
    1.25%
    20%
    $1.18
    $0.73
    $0.45
    2 TCF
    $5
    1.25%
    20%
    $2.35
    $1.46
    $0.91
    3 TCF
    $5
    1.25%
    20%
    $3.52
    $2.19
    $1.36
    4TCF
    $5
    1.25%
    20%
    $4.69
    $2.91
    $1.81
    5 TCF
    $5
    1.25%
    20%
    $5.87
    $3.64
    $2.26
    10 TCF
    $5
    1.25%
    20%
    $11.74
    $7.29
    $4.56
    14 TCF
    $5
    1.25%
    20%
    $16.43
    $10.15
    $6.33
    20 TCF
    $5
    1.25%
    20%
    $23.47
    $14.57
    $9.05
    30 TCF
    $5
    1.25%
    20%
    $35.21
    $21.86
    $13.56
    40 TCF
    $5
    1.25%
    20%
    $46.95
    $29.15
    $18.08
    50 TCF
    $5
    1.25%
    20%
    $58.69
    $36.44
    $22.60
    60 TCF
    $5
    1.25%
    20%
    $70.42
    $43.73
    $27.11
       Table 2
     
    Discussion of Risks
     
    As with any investment there are risks involved in owning the Treasure Island Royalty Trust. It would be irresponsible for anyone to portray an investment with zero downside, and I believe the valuation section presented above paints a very positive picture of the potential for Treasure Island. The valuation section may not do a good job of discussing the risks inherent in owning this trust. The largest risk of course is involved with the operators of the properties. If for any reason Energy XXI, or McMoran Explorations were to go bankrupt or be unable to complete their wells, then this would obviously impact the trust in a significantly negative way. Additionally, if the wells drilled do not find as much gas or oil as has been previously projected, then this would obviously impair the value of the trust units.   These risks are perceived to be low, as both companies have experienced management, and good credit ratings with excellent access to capital as evidenced by their recent equity offerings. 
                Other risks which should be carefully considered are the risk of force majeure events such as a hurricanes and earthquakes. These types of events could damage equipment and curtail production for an extended period of time. It should also be considered that all the blocks of land in the trust are off the coast of Louisiana, and are in a historically active hurricane zone. While the last 5 years have been relatively placid, there is no guarantee that future weather will be as conducive to operating oil and natural gas rigs in the Gulf of Mexico. 
                Additionally, it should be noted that the demand for natural gas is moderate, but supplies have been growing a great deal in recent years (see figure 5). Excess supplies have caused downward pressure on prices and could potentially keep prices down for an extended period of time. The advent of horizontal drilling and fracking has opened up the natural gas industry, and has allowed drillers to tap huge fields like the Fayetteville Shale in Arkansas, the Barnett Shale in Texas, and the Marcellus Shale in Pennsylvania among others. While this should be a concern, it should be noted that it is on the whole less expensive to recover pockets of gas from the sub salt fields than from the shale fields. Additionally, the abundance of natural gas in America, and declining crude oil reserves will hopefully cause a trend towards an adoption of natural gas as the major source of energy for this country in the future
      
    Estimated Recoverable Natural Gas Reserves located in
    United States Shale Basins
            http://investletters.com/blog/wp-content/uploads/2009/07/estimated-recoverable-natural-gas-for-select-shale-basins.jpg
                       Fig. 5 (Modified from Daily Oil Bulletin, May, 4 2009)
     
    Treasure Island and Margin of Safety
     
    The margin of safety principle in investing was made famous by Benjamin Graham and by his star pupil Warren Buffett.  The principle is borrowed from engineering, and goes something like this; if you're going to build a bridge that can allow a truck weighing 10 tons to cross, you don't build a bridge that can only hold 10 tons, you build a bridge that can hold 20 tons.  The ability for the bridge to hold an extra 10 tons over the requirement is the margin of safety.  In value investing, the margin of safety is similar. A good example of this is when an investor purchases shares in a company that is trading below its current book value. The idea here is that the investor has a safety net if his investment were to depreciate further. The investor can seek solace in the fact that if the company were to be broken apart, he would still receive his principal investment back plus the margin between the share price and the company's book value. 
    With Treasure Island, the margin of safety needs to be slightly re-conceptualized.  Treasure Island is an investment with significant risks, and very significant rewards.  However, as stated in the risks section there is a small chance that an investor’s entire principal could be wiped out if McMoran or EXXI are unable to extract any oil or natural gas from the Treasure Island properties.  Since there is a growing body of evidence indicating that a massive amount of hydrocarbons lie under the salt weld, there is a slim chance of McMoran and Energy XXI not being able to extract at least some amount of hydrocarbons.  However, since there is little chance of losing one's entire principal, this trust should be classified as a speculative bet.  If one thinks of this as a speculative bet than the margin of safety becomes clearer. 
     As a speculative bet, it is recommended that an investor only allow Treasure Island to become 1-3% of his entire portfolio.  At this small percentage, a loss of one’s entire principal will be minimal to an investor’s balance sheet; however, it will also be small enough to accrue meaningful tax credits in the form of capital losses which can offset capital gains.  The tax code (currently) allows investors to use up to $3,000 a year in capital losses as a tax credit against capital gains.  If the speculative bet is kept to say $9,000 and Treasure Island goes down to $0.00 a share, then the entirety of the investment can be recouped over the next 3 years.  While this margin of safety may not be very comforting, and would provide a loss on principal relative to a treasury bond held over that same time period, it does give an investor some confidence that in a worst case scenario they have a safety net. Of course, if you have a very large asset base—say over 5 million dollars, then this margin of safety would probably not be appropriate.
    Obviously, if the margin of safety is a tax credit against potential losses, then it is recommended that Treasure Island be held in a non retirement brokerage account so that this benefit will be available to the investor if he needs it.  However, if Treasure Island does start producing oil and natural gas, then it is recommended that the investor transfer this asset over to a retirement account so that he can shield future royalty distributions from taxes.  If one is already above retirement age, then taxes should be done with care, as distributions are not dividends and do not need to be taxed at one’s effective tax rate but rather as a negative interest accrual against the principal investment.  The discussion of taxes in relation to trusts is very complicated, and deserves a separate article all together.    
     
    Executive Summary
     
    Treasure Island Royalty Trust is an exciting opportunity with tremendous potential and minimal downside as long as an investor limits his exposure to 1-3% of his entire portfolio. If an investor can do this, then a small speculative bet will have limited downside due to the current tax laws concerning capital losses. Portfolio concentrations above 5% are strongly discouraged, particularly for high net worth individuals, since it may take an excessive amount of time to recover ones principal through tax credits. 
                The ultimate potential for this trust will be determined by how successful McMoran Explorations and Energy XXI are in drilling the Black Beard and Lafitte sites. If McMoran and Energy XXI are accurate in predicting a pay load of 60 Trillion Cubic Feet for the three well sites, then Treasure Island will prove to be a once in a lifetime investment. Even if McMoran and Energy XXI are only able to extract a ¼ of the 60 Trillion Cubic Feet, Treasure Island would still prove to be a phenomenal investment relative to treasuries or standard annual rates of return on the S&P 500.
     
    Disclosure

    I am long Treasure Island Royalty Trust, but I have no positions in other stocks mentioned in this article, including BP, McMoran Explorations, Energy XXI and Exxon.


     


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: I am long Treasure Island Royalty Trust, but I have no position in other stocks mentioned in this article, including BP, McMoran Explorations, Energy XXI, and Exxon.
    Stocks: MMR, EXXI, XOM, BP, TISDZ
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Comments (25)
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  • Jeep
    , contributor
    Comments (1874) | Send Message
     
    Mr. Duade:

     

    While I was quite familiar with EXXI and MMR, I hadn't heard of the trust. It sounds interesting--but according to some geologists there is a non-trivial chance that the ultra-deep reservoirs will prove to deplete extremely rapidly. If that is correct, there will be no value here.

     

    Might a better way to play the ultra deep be out-of-the money leaps on MMR? If there really is all that gas there, and MMR can extract it, the price of the stock will skyrocket.

     

    Anyway, you have written a very interesting article based on a lot of good research.

     

    Jeep
    5 Dec 2010, 07:44 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » Jeep you could be right. I'm not a geologist, but I've heard that what you're referring to could be a possibility. My understanding is that the reserves could be extracted at a rate of 100 million Cubic Feet a day, per well. This rate depends on the pipe diameter and other variables along those lines. Jim Bob has mentioned these flow rates during his recent conference calls, so I'm hoping that he's correct. I also believe that they are benchmarking these figures from the ultra deep Davy Jones wells which have started producing recently. The impact for the trust is that if natural gas is produced from these wells very quickly, you may see the value of the trust be produced in only several years as opposed to 5 to 10 years which were the arbitraty time lines that I choose for my net present value calculations. If that were to happen, then you might see the price of the units sky rocket above what the net royalty interest could be. Bottom line is that the trust is admittedly speculative, but has great potential. My feeling is that a small bet on the trust is worth while, but that owning this trust is not for everyone.

     

    Thanks for the post!
    5 Dec 2010, 09:56 PM Reply Like
  • Jeep
    , contributor
    Comments (1874) | Send Message
     
    Mr. Duade:

     

    Davy Jones hasn't started producing yet. An appraisal well is being drilled and MMR has ordered the equipment necessary to conduct a flow test in 2011. Apparently the reservoir is of very high quality, but how much gas is in there appears to be an open question.

     

    The concern about the ultradeep reservoirs was outlined in an Oil and Gas Journal article in August (I believe). the authors pointed out that the gas in ultradeep reservoirs tended to dissipate over the eons because of the heat and pressure, and that unless subsalt ultradeep reservoirs are somehow different (which they might be), finds such as Davy Jones might prove to have only a very limited amount of gas.

     

    Like you, I'm not a geologist, so I don't really know what to make of these contentions. But until Davy Jones has an extended flow test, the question of whether an ultradeep reservoir can contain a material amount of gas is out there.

     

    Jeep
    6 Dec 2010, 09:13 AM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » Jeep,

     

    Mea Culpa. I just re read McMoran's December, 2nd release and you're correct. I will have to look for the article you're referencing from Oil and Gas, it sounds interesting and potentially material to the value of the trust. I appreciate your comments and insight, they've been very helpful.

     

    Best,
    James
    6 Dec 2010, 12:19 PM Reply Like
  • Jeep
    , contributor
    Comments (1874) | Send Message
     
    James:

     

    No mea culpas necessary! In any piece as long and detailed as yours there will be some points that require further work.

     

    Anyway, it was the August 2, 2010 issue of the Oil and Gas Journal. It can be found online here: www.ogj.com/index/arti..., though that might be for subscribers only. In case it is, here is the authors' conclusion:

     

    "It is the authors' belief that sands below the 3.5 shale ratio cutoff depth, in the environment that exhibits a pressure regression, have been "breached" over geologic time and essentially only residual gas remains in the reservoir. These reservoirs generally have good initial production and pressures but deplete over short periods.

     

    It is arguable that the ultradeep gas sands found at Davy Jones do not fit within the above described cutoff parameters. The magnitude of the data acquired over the years to arrive at our conclusions is from wells drilled at considerably shallower depths than 20,000 ft. Also, we have limited data from wells in environments where the pay intervals are below a "salt weld."

     

    At this time, the significance of the salt weld on our conclusions is unknown. Further, we have not seen the actual data from the deep pay interval in the Davy Jones apparent discovery well. We will have to await the testing of the pay interval before final conclusions can be drawn."

     

    Like everyone, I always like to see a production test first, but this article caught my attention because if the authors are correct, ultradeep gas might be a chimera.

     

    Jeep
    6 Dec 2010, 01:54 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » Thanks Jeep. For the sake of my investment I hope the scientists are wrong on this, however it will be interesting to see how it all shakes out. I appreciate you bringing my attention to their conclusions, and giving me one more reason to stay awake at night. Thanks again for your input!
    6 Dec 2010, 06:18 PM Reply Like
  • Jeep
    , contributor
    Comments (1874) | Send Message
     
    James:

     

    I suppose staying awake at night is the price one pays for being an investor, but this is my big worry on these reservoirs--probably in part because I simply don't know enough about geology to know how reasonable the worry is.

     

    Anyway, the chance to share information like this is one of the things I very much like about Seeking Alpha, and it is dependent on articles like yours to make it work.

     

    As for this, let us hope for the best.

     

    Jeep
    7 Dec 2010, 09:30 AM Reply Like
  • texxustrade
    , contributor
    Comment (1) | Send Message
     
    Mr. Duade,

     

    Excellent overview of the ongoing operations in the development/execution of GOM 2.0 by EXXI and MMR. While the TI Trust certainly has a lot of upside potential, IMHO entities that exist purely to collect royalties carry far greater risks than corporations that are actively working in tangible ways to realize the underlying potential of this play.

     

    Never the less you've put together an excellent primer here for anyone who is interested in the geology of this area and it's long term potential.

     

    Thanks for your efforts to educate the masses and good luck with your long position here.

     

    Mutt
    5 Dec 2010, 09:58 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » Tex,

     

    Thanks for the comment. I'm hoping that MMR and EXXI find a ton of natural gas on trust lands, but you're absolutely right to point out that there are no guarantees. It's very possible the trust could wind up realizing no royalties, and the unit holders could get completely wiped out. Hopefully that doesn't happen, but if it does, limiting a position in the trust to 1-3% of your portfolio would help take the sting away. Thanks again for your comment, I'm glad you enjoyed the article.

     

    James
    5 Dec 2010, 10:17 PM Reply Like
  • nattylong
    , contributor
    Comment (1) | Send Message
     
    Thanks for this good article. I have a few questions about the trust. You have specifically mentioned a few blocks - ST 144 (BB East), EI 222, 223 (Lafitte), ST 167, 168 (BB West). Are these the only blocks the trust has a royalty interest or does it have royalties for all of "Treasure Island"? Does it include Davy Jones? The provided MMR presentation link lists it as block SMI 234.
    6 Dec 2010, 10:44 AM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » The trust only has an interest in the production from a specific set of blocks. Unfortunately for the trust, Davy Jones is not included. There are additional blocks of land that the trust has a claim on, but none are currently being considered for production or exploration that I know of. Let me know if you want any clarifications on this.
    6 Dec 2010, 12:09 PM Reply Like
  • dick roberson
    , contributor
    Comments (61) | Send Message
     
    Excellent presentation on the potential value of TISDZ.

     

    Within the TISDZ Trust agreement it declares that no more than 8% of annual royalty income can be withheld for the expenses and fees of the administration of the Trust. Your annual 80% payout figure can be increased to 92% to the shareholders. This will raise your estimated
    annual distribution potential substantially.
    7 Dec 2010, 09:54 AM Reply Like
  • Bonebagger
    , contributor
    Comment (1) | Send Message
     
    I have held the shares since Aug 2006 and appreciate the informative piece you have written here. What interests me are the activities of the major shareholders in the Trust, especially Richard McKenzie Jr. Have you any information on his background and rationale for the 24.56% stake he has amassed? Do you think there is there any way to find out who the beneficial holder is?
    19 Jan 2011, 02:03 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » Thanks for reading Bone. I'm a bit hazy about the story behind Mr. McKenzie and his seven bridges foundation. I know that Seven Bridges as of November, 2010 had 1.2 million shares. I've heard some say that Seven Bridges will reduce their holdings even further. This would probably be a good thing as it reduces the overhang of a big player owner dumping his shares on the market all at once. Just my opinion, if I hear of anything else I'll post it here. Thanks for the comment!
    19 Jan 2011, 07:39 PM Reply Like
  • joviks
    , contributor
    Comment (1) | Send Message
     
    Can you layout your thinking on the timing of future events for the Lafitte, BBE and BBW wells? Just wondering when possible catalysts for the stock will materialize and the production timing underpinning your valuation models. Thank you and enjoyed reading your article.
    27 Jan 2011, 04:04 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » That's a tough question to answer because it really depends on A) the amount of hydrocarbons they discover, and B) when they want to get it out of there. Recent conference calls from Jim Bob have indicated that they have had 178 feet of net pay in the the upper portion of Black Beard East, and additional pay zones down further. An additional rig has been placed on Black Beard East, and it seems as if McMoran and EXXI are going to try and start producing from BBE as soon as this year or very early in 2012. At Lafitte they are still drilling, and are probably somewhere right above the salt at the moment. The next few months will give us more information there. As far as Black Beard West goes, I think that they will start producing there after Black Beard East, because I believe the equipment that they need to get at the pay zones is more costly and difficult to use than the equipment needed to get at the pay zones at BBE. So the short answer is that BBE should start producing in the next 12 months, Black Beard West will eventually produce, and Lafitte is a wild card until they can prove that there are actually hydrocarbon deposits there. If Lafitte does have deposits, then I would expect it may be 18-24 months till we see a royalty stream from that plot. One additional note is that the trust is in the process of discussing an additional plot (Calico Jack) with McMoran. This plot looks to belong to the Trust, and could potentially be drilled in the future. For more information I would suggest heading over to the TISDZ yahoo message board, the posters there are actually extremely knowledgeable, and often provide great insights. Hope this helps.

     

    James
    27 Jan 2011, 05:20 PM Reply Like
  • FL SHRHLDR
    , contributor
    Comments (54) | Send Message
     
    Extremely well done article. However, there has been insider selling. Any thoughts?
    21 Jun 2011, 03:11 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » HI FL SHRHLDR,

     

    Thanks for reading, and thank you for the kind words. The insider activity is interesting, but I unfortunately don't have too many insights here. Mr. Richard McKenzie is the largest shareholder and owns shares individually and through a trust called Seven Bridges which he runs. Between his personal holdings and the trusts holdings the total ownership is about 11.1 Million units, or in other words about 25% of the total outstanding shares. If you look at the selling, it typically comes in large block trades of 50,000-200,000 units at the market price. Some have speculated that Mr. McKenzie is actually trading these shares with industry insiders as some sort of favor. In reality we have no idea what the motivations for selling are. In my opinion the trust will trade based on fundamentals going forward. However, if Mr. McKenzie decides to suddenly dump all his shares at once this could cause downward pressure on the share price. I think the probability of this happening is low, but still something to consider. Hope that helps!

     

    James
    21 Jun 2011, 11:28 PM Reply Like
  • NewEnergyGuy
    , contributor
    Comments (4) | Send Message
     
    James:

     

    Any thoughts now that MMR updated the street yesterday? What do you now think is recovery potential to the Treasure Island properties?
    30 Jun 2011, 07:08 PM Reply Like
  • NewEnergyGuy
    , contributor
    Comments (4) | Send Message
     
    Sorry - new here but James what do you think of Treasure's properties after the update from MMR yesterday?
    30 Jun 2011, 07:12 PM Reply Like
  • James Duade
    , contributor
    Comments (291) | Send Message
     
    Author’s reply » Hi New Energy Guy,

     

    A few interesting notes came out of the presentation yesterday. The first is that Lafitte had a kick (see slide 18), which is indicative that hydrocarbons could be present in the upper sands. Hopefully we'll get some more information about this once some logs are done on this section. I'm hopeful that we could get information as early as McMoran's Q2 conference call in Mid July.

     

    The other interesting note that came out is that McMoran is considering drilling Ship Shoal 188 (slide 21), as they believe that Ship Shoal has a similar stratigraphy as BBE. The lease on Ship Shoal expires on September 30th, but McMoran only needs to deepen the BBW well in order to keep the lease on Ship Shoal.

     

    The other good news, which has been discussed before is that McMoran is planning on drilling BBE2 to produce the upper sands by early 2012. You can find the slides from the presentation below.

     

    www.mcmoran.com/presen...

     

    As far as the recovery potential goes, I personally think that Lafitte, BBE and BBW will all produce at some point. BBE will of course be the first, then Lafitte, and hopefully BBW and Ship Shoal 188 after that. It's hard to say how many TCF or condensate may be produced. At this point it looks like BBE may have 1-2TCF plus the potential for condensate (potentially oil). BBW, Lafitte, and Ship Shoal are anyone's guess. Additionally there is a chance that the lease for Calico Jack will be added to the trusts holdings (this is currently in dispute with McMoran).

     

    Despite all the good news, I still think that one should exercise caution with buying units. The ultra deep is still speculative at this point as some posters above have indicated. Hope this answers your question.

     

    Cheers,
    James
    30 Jun 2011, 11:38 PM Reply Like
  • NewEnergyGuy
    , contributor
    Comments (4) | Send Message
     
    Thank you very much - your work on this name has been great
    1 Jul 2011, 03:00 PM Reply Like
  • FL SHRHLDR
    , contributor
    Comments (54) | Send Message
     
    Yes thank you for your response. I own shares of Tel Offshore Trust. I am concerned that they are in a similar boat. They are in the process of shopping around themselves because they need cash. I am concerned that Treasure Island could face a similar scenario. Best regards
    22 Jun 2011, 08:53 AM Reply Like
  • NewEnergyGuy
    , contributor
    Comments (4) | Send Message
     
    James:

     

    Any thoughts now that MMR updated the street yesterday? Do you think the recoverable reserves have changed for the Treasure Island properties?
    30 Jun 2011, 07:09 PM Reply Like
  • sammy so
    , contributor
    Comments (13) | Send Message
     
    James:
    Are you still following this stock? Any thought about the situation now that MMR is being taken over by FCX?
    21 Feb 2013, 07:04 PM Reply Like
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