Oil & Gas royalty trusts are often presented as relatively low-risk, high-distribution investment vehicles providing exposure to commodity price upside. While clearly there is some truth to such characterization, underlying operational and financial uncertainties can nonetheless be quite significant. SandRidge Mississippian Trust I (NYSE:SDT) is the case in point.
Ostensibly, the Trust's operational risks are moderate. Unlike a typical exploration and production company, the Trust has little exposure to new drilling (by this time, the majority of its 160 gross wells have been brought on production) or field operating costs (paid by the sponsor, SandRidge Energy (SD)). The Trust does not have any debt, is burdened with only minimal amount of administrative overhead, and distributes all available cash every quarter. Essentially, the Trust will from now on passively deplete its producing reserves, passing net revenues on to its unitholders. Commodity price hedges and subordination mechanism are designed to provide additional predictability to distributions, at least in the near term.
However, there is one major operating risk that cannot be eliminated: well performance. Investors have already seen the Trust's unit price decline by more than half from its peak levels in reaction to two negative type curve revisions disclosed by SandRidge during 2012 and a massive write-down of the Trust's oil reserves that followed at year end. (I should note that IPO investors have seen only minor losses to date: after factoring in $6.11 of cumulative distributions per unit, current price of $14.08 translates to a less than 10% loss from the April 2011 IPO price of $21.00.)
Well performance issues in the Mississippian Lime play have received significant amount of investor attention recently. As a reminder, the biggest disappointment has related to the much lower oil productivity of the wells than initially estimated. Clearly, this information is already reflected in the Trust's production results and discounted, at least to some degree, into the units' price. However, it would be incorrect to think that well performance worries are behind us. As discussed in this note, a close review of the Trust's production data raises a concern that the Trust's future production and reserve estimates are at risk of additional downward revisions.
Another major risk relates to the possibility of "valuation complacency" induced by the units' enormous current yield: 16.8%, based on $14.08 closing price on July 1, 2013 and the most recent $0.59 distribution. The exceptionally high current yield masks what may prove to be a poor internal rate of return over the life of the Trust. Even barring any further well performance disappointments, the Trust's latest reserve report implies that the units may be vulnerable to a substantial (20%-35%) downward re-pricing. Technical challenges of valuing the Trust's units exacerbate the mis-valuation risk - while one would think that the Trust's common units should be relatively simple and transparent for analysis, a closer look reveals more complexity and uncertainty than may appear on the surface.
NOTE: Please read the Disclaimer at the end of this article.
Deteriorating Operating Results
Persistent decline in the Trust's oil and NGL production is perhaps the most perplexing operating trend that seems central to the understanding of the Trust's intrinsic value.
Since 2010, SandRidge has maintained a fairly even development pace on the Trust's acreage, equivalent to approximately 13 gross wells with 28.5% net revenue interest drilled per quarter. A total of 37 Initial Wells (average ~50.7% NRI) were drilled in 2009-2010 and another ~123 Development Wells (average ~28.5% NRI) were drilled in 2011-2013. One would expect the Trust's production to have shown steady growth quarter over quarter, as volumes from approximately equal number of new net wells added on top of the continuously growing stack of "production tails" from older vintages. This has not been the case however. The Trust's production actually declined during 2012, as summarized by the two graphs below.
Quite telling is the following operational statistic: the Trust's Q1 2013 oil and gas volumes (which reflect production during the three months ended November 30, 2012) declined by ~7% year-on-year on a BOE basis, including ~18% decline in oil volumes, while the number of producing wells actually increased from 84 to 134. Such outcome can only be possible if average well productivity deteriorated during 2012.
Particularly surprising and worrisome is the most recent operating report (which reflects production during the three months ended February 28, 2013). The quarter was marked by an 18% sequential drop in oil and NGL volumes, the strongest quarterly decline since the Trust's inception. In fact, during the quarter, the Trust produced less crude oil than was covered by its hedging arrangements. Given that the press release did not disclose any unusual operating events that would help explain the reduction in volumes, natural well declines would seem to be the most likely cause.
The acceleration of production decline is counterintuitive. Even if one were to assume (implausibly) that all the new wells - 11 gross in total - were turned in-line towards the end of the period and as a result made little contribution to the production during the quarter, it would still be difficult to rationalize such a steep reduction in volumes. In a typical shale well, production decline "flattens" as time goes on. As of February 28, 2013, the Trust's portfolio consisted of ~149 producing wells, the majority of which had been producing for more than a year and therefore were past the steepest portion of their individual decline curves. An 18% quarterly base decline rate for the portfolio as a whole would be abnormally high and require some assumption stretching to be reconciled within the framework of a type curve-based model. While an explanation other than well performance may exist, the data point is without doubt concerning. The oil production trajectory needs to be watched closely over the next few quarters.
The Trust's cash flows are highly levered to its oil and NGL volumes which have contributed over 70% of the Trust's royalty income in the past several quarters. While the impact from declining oil production has been partially offset by the improvement in natural gas prices since mid-2012, the Trust's royalty income has been on a downward trajectory for essentially six quarters, notwithstanding the steady pace of development drilling.
These observations and concerns are further confirmed by a more detailed and rigorous modeling of the Trust's well portfolio. An attempt to match the model to reported historical production data and the 2012 year end reserve report leads to a conclusion that the Trust's average drilling results materially deteriorated during 2012. Furthermore, it is possible that some of the Trust's recent wells were characterized by much steeper initial declines than what is assumed by the type curve.
Can the Trust's Operating Performance Turn Around?
Drilling results in the Mississippian Lime formation have been notoriously difficult to predict and a positive surprise is certainly possible. However, as of February 28, 2013, the Trust had only six (gross) wells remaining in its development backlog, with three additional wells waiting on completion or connection. These remaining wells - which represent less than 5% of the total well count on a revenue interest-adjusted basis - would have to include several truly outstanding "oily" wells for the results to make a material impact on the units' valuation. Given the track record of the last eighteen months, it is difficult to count on such a scenario. It would also seem logical to assume that in its development plan, SandRidge has prioritized its most promising "oily" locations to maximize net present value, leaving the less attractive locations to be drilled at the very end.
The bottom line remains that the Trust is exiting its development phase with an oil production rate that is substantially below what was anticipated at the time of the IPO. Production decline rate may also prove steeper than estimated in original projections (and, possibly, what is implied by the most recent type curve). These two factors will impact the amount of recoverable oil reserves and valuation.
Reserve Report Analysis
The Trust does not provide individual well performance data or discussion. In the absence of such disclosure, the reserve report prepared by independent engineers (Netherland, Sewell & Associates) is an important source of "informed" future production estimates. Analysis of the 2012 year end reserve data is summarized below.
Using the reserve report as a starting point, the following commodity price sensitivities can be derived for the PV-10% of the Trust's future net royalty income.
(Source: Zeits Energy Analytics)
Taking the analysis few steps further, one can arrive at the following net asset value estimate per common unit:
The $8.84-$9.46 valuation range implies a 33%+ downside risk to current unit price. It is important to note that the valuation implicitly assumes that the market will require a 10% return on investment in the Trust. The 10% discount rate is on the high side of what seems to be typical for the royalty trust category of equities but, arguably, is appropriate given well performance uncertainties, commodity price risk, and potential negative impact of rising interest rates on the unit price. However, even if lower discount rates are used, implied downside to current unit price is still significant. The table below summarizes present values of future distributions on common units using a wide range of discount rates. The distribution estimates are based on my operating model which simulates production from each of the 160 wells in the Trust's portfolio and is calibrated to match the Trust's historical production and reserves data. (For the time being, the model treats the sharp oil and NGL production decline during the December 1, 2012 - February 28, 2013 period as partially attributable to the timing of the well completions. However, should the next press release, which is expected within a month, confirm the negative production trend, a downward revision to the model will be required). The model results summarized in the table below are based on a flat $100 WTI/$4.50 Henry Hub commodity price assumption (which corresponds to the "High" column in the spreadsheet above).
Another useful metric is estimated internal rate of return on an investment in the Trust's units at various assumed current prices over the life of the Trust (table below). Based on the model, a new investor in the Trust's common units would be looking at a ~2.1% IRR over the life of the trust.
The low per unit valuations and investment returns reflect steep estimated production decline, particularly for the oil component which accounts for as much as 60% of the royalties' net present value (please note that total amount of production net to the Trust's interest in this model still matches the reserve report).
The model predicts fast decline in distributions on common units driven by lower production volumes and subordination support expiration, as illustrated by the following graph.
Potential Upside To The Valuation
The illustrative valuation discussed above relies, in significant degree, on proved reserves estimates by Netherland Sewell which are meant to be conservative metrics. Should actual decline curves for the Trust's wells prove flatter than predicted by the type curve used in the estimates, upward revisions to reserves and valuation would follow. In fact, in its most recent presentation, SandRidge includes a slide that suggests that the company's wells in "development focus areas" have begun to outperform the type curve after year two.
It would be premature, however, to extrapolate the conclusion implied by this slide on to the Trust. While the graph may adequately depict well performance in SandRidge's "development focus areas," it is not at all obvious that the same is true for the Trust's well portfolio. Moreover, a careful comparison of the graph above with the type curve graph for a broader well sample from SandRidge's earlier presentation, which is shown below, leads to a question: are wells outside "development focus areas" in fact underperforming the type curve and are not "flattening" fast enough?
It is important to note that the uncertainty related to the shape of the Trust's long-term production curve remains significant at this point. This factor alone creates a material risk to the valuation, both to the downside and upside.
Commodity Price Considerations
The Trust's valuation is obviously dependent on the underlying commodity price assumptions. Price assumptions for the first several years are particularly important as declining production volumes and time value of money diminish economic contribution from the years further out on the timeline.
The NYMEX futures curves help to put commodity price assumptions in perspective. Notably, the WTI futures show strong backwardation, with deliveries in 2016 and beyond trading below $85 per barrel. The front 36 months currently average $88.41 per barrel (7/01/13 close). Henry Hub futures, on the contrary, are in contango, with the front 36 months averaging $4.01 per MMBtu (7/01/13 close). In this context, the commodity price bracket in the illustrative valuation above was chosen to be reasonable but not overly conservative.
Type Curve Considerations
Production from horizontal fracture-stimulated wells in the Mississippian formation is characterized by steep initial declines. The graph below from SandRidge's most recent presentation shows company-estimated production profile from a typical Mississippian well. The graph indicates that the oil component in the production stream may decline as much as 76% from its initial rate during the first year ("Initial Decline" estimates are shown on the right-hand side of the slide). Gas production declines are less steep but are still very substantial, estimated at 62% in year one. As time goes on, production declines become progressively shallower and the decline curve essentially "flattens" at a low annual decline rate after several years. As the graph indicates, a typical well that started out at 140 barrels of oil per day and 790 Mcf of natural gas per day, in ten years may be producing less than 10 barrels of oil and less than 100 Mcf of natural gas per day. The very fast initial production declines are the reason for the expected decline in quarterly distributions on the Trust's units.
Each individual well will of course have its specific "realized" decline curve which may differ materially from the type curve. The type curve is a model estimate of future "typical" performance based on engineers' best judgment at present time. It is important to note that the Mississippian Lime play is inordinately "statistical" in nature. The term "statistical" is often used in the industry to refer to resource plays where drilling results vary significantly from well to well and are difficult to predict. In the case of the Mississippian, variability of drilling results has proven to be extreme. Such variability relates to all key well performance metrics, including initial production rates, oil/gas mix, initial decline rates, and the shape of the decline curve. As a result, the concept of the "type curve" becomes particularly difficult to apply to predicting performance of each individual well. Estimates are inevitably handicapped by wide uncertainty ranges.
In the context of this wide variability, some lumpiness in the Trust's quarterly results is to be expected. However, a consistent weakness in oil and NGL production data over several quarters in a row is surprising.
What to Expect In the Short Term?
The Trust's unit price brushed off the disappointing Q2 production results released on April 25 (for the three months ended February 28, 2013). What should one expect when a new quarterly report is announced three-four weeks from now (will provide operating results for the three months ended May 31, 2013)?
Oil and NGL production volume will be the most critical data point to watch, in my opinion. I estimate oil and NGL volumes to show a sequential uptick during the quarter, from the 123 MBoe reported in the prior period, as the remaining nine development wells are turned in-line. A sequential decline in oil and NGL volumes, even by a smaller percentage than in the prior quarter, would be a disappointment and, in my opinion, would confirm with certainty asset performance issues discussed above. The Trust's type curve and reserve estimates may be at risk.
Barring continued deterioration in production volumes, the Trust's rich valuation may not become obvious for another several quarters as common units will enjoy enhanced distributions supported by the subordination mechanism. I estimate the next two distributions on common units to be at Subordination Threshold level (~$0.61 per unit for each of the next two distributions). However, at the end of Q2 2014, all subordinated units will automatically convert into common units and will begin participating in distributions on a pari passu basis. As a result, distribution on common units will see a particularly sharp drop in Q3 2014 (27%-28% sequentially, in my estimate). Within two years, distributions on common units may fall by approximately half from their most recent level and will continue to decline thereafter at a brisk, albeit gradually improving, annual rate (assuming constant commodity prices). The risk of a re-pricing is the highest during the next twelve months, in my opinion, as investors start to focus on the approaching expiration of subordination support.
DISCLAIMER: Opinions expressed in this article by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. The author's opinions expressed herein address only select aspects of potential investment in SandRidge Mississippian Trust I units and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential investors conduct thorough investment research of their own, including detailed review of the Trust's SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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