Tricks That Inflate The Value Of Oil And Gas Trusts

Includes: ECT, HGT, NDRO, XOM
by: The Forensic Accountant

Oil and gas trusts are the used cars of stocks. Value may abound, but if you don't look under the hood, you'll get taken for a bad ride.

Recently, I considered purchasing a set of oil and gas trusts. I like trusts because they offer steady income streams. However, trusts can also be overpriced and I didn't want to overpay. I'm frugal guy; I always have time or money, but never both! As it turns out, trusts don't make it particularly easy for the casual investor to determine what they are really worth. They don't forecast future distributions, they rarely provide much information on future revenues or costs, and what they do provide tends to be buried deep in their quarterly and annual reports.

As this happens to be one of those times when I have "time," I conducted an extensive review of historical SEC filings by oil and gas trusts. This review unearthed a number of practices that the trusts employed to raise their perceived value in the eye of the investor... and which might lead investors to overvalue trust units! This article summarizes the practices that I found. My advice to the individual investor is: watch out for these pitfalls!

The basics

Oil and gas trusts are a type of commodity investment in which an investor purchases the right to the future proceeds from oil and gas sales from a group of wells over time. Trusts are a convenient way for well proprietors to fund their capital investments because they allow the proprietor to recover the costs of constructing wells quickly through the sale of trust units, which reduces their risk to fluctuations in future well production and commodity prices. For the investor, these trusts offer an annuity-like stream of income over time that may offer returns greater than that of other investment income streams over the long term.

However, trusts have a significant dark side. A trust's value is entirely dependent on its future distributions, which are, themselves, a function of the quantity and rate of future oil and gas production, the sales price, and various costs subtracted from proceeds. Who has the best information about future production and cost? The well proprietor-the very same one that is selling the right to future production proceeds to the trust in the first place. Much like the seller of a used car on CraigsList, well proprietors have every incentive to pump up the good news ("new tires!") and bury the bad information ("slight oil leak") way down in the bottom of a report, or not report it at all.

Oh, the *legal* games we play

"Never Ask a Well Her Age"

So let's take a look at well production. The production of a well and the proceeds from sales of that production decline with well age. While this decline tends to stabilize as a well matures, it is typically most difficult to predict within the first few months after a well is completed. I examined the SEC filings for a half dozen trusts, each in their entirety or for a minimum of 3 years of historical reporting, and not a single trust reported the age of its wells or even performance down to the well level. Kudos to Hugoton Royalty Trust (NYSE:HGT) and Enduro Royalty Trust (NYSE:NDRO), which sometimes break out their production by sub-properties.

"The Well Shell Game"

But well proprietors can go one further. If a proprietor staggers the creation of new wells over time, the related trust's overall production numbers may be misleadingly stable. If you want to see this technique in action, check out ECA Marcellus Trust I (NYSE:ECT)'s filings for the past three years; while they did report on the completion of wells (quarterly), this information was buried in their 30+ page 10-Q from November 2012:

"ECA was obligated to drill all of the PUD Wells no later than March 31, 2014. As of November 30, 2011, ECA had met its drilling obligation and had drilled 52.06 Equivalent PUD Wells, calculated as provided in the Development Agreement."

If you didn't know to look for that line, you might have missed it… and missed one of only two keys that ECT's production was going to crater in Q4 2012, as shown in the chart below. And what's a PUD well, you ask? A great term to use if you want to make it harder for the investor to determine exactly what the trust really owns.

Without any new wells, ECT

"Getting worked over"

In response to declining production, a proprietor can "workover" a well. Most proprietors have teams that workover the various wells owned by the proprietor. However, the trusts, themselves, have no such teams. Some trusts may be able to contract out well workovers or receive them on an ongoing basis from the proprietor. For example, Enduro Resource Partners LLC, which is the proprietor behind NDRO, recently publicized their plans to workover a number of wells. Of course, they are also charging the trust $14M-$16M annually for the privilege (see NDRO's 8-K, filed 10/9/13).

But other trusts don't appear to have such a provision. ECT, for example, doesn't list any charges for well workovers or maintenance. Without such workovers, ECT's wells may decline faster than others-but, of course, it isn't explicit in ECT's SEC filings, so it's hard to tell.

"The Hedge Game"

In addition to hiding information on well production, trusts also obscure information on the prices paid for oil and gas. Obviously, when a proprietor determines who they sell to and at what price, it could create the opportunity for preferential pricing. We found lots of snide comments on chat boards alluding to this, but didn't find evidence of any blatant tricks. Unless you look at the hedges, that is.

Most of the trusts that we reviewed were also endowed by their creators with certain rights to sell their products at a price that is way, way above market. ECT, for example, had hedge and swap contracts in place to sell upwards of 25% of their gas production for $6.25 (when the spot price was around $3). But these contracts are temporary, which means that realized price for gas and oil sales will drop when the contracts run out. Not to pile-on ECT, but not only did they lose production in late 2012, they also lost revenue from the $6.25 hedge! (Don't worry, ECT has another hedge at $5 that expires in Q1 2014.) Of course, if you only look at the distribution history, you won't see the drop before it happens. Kudos to NDRO, whose financials actually spell out the profits from these hedges.

"Hidden Costs"

Before releasing funds to the trust, well proprietors deduct a series of fees and costs, variously described as "production," "overhead," "administration," "leases," "transportation," "development," etc. Other than the title of the cost, most trusts provide little information on what each cost actually pertains to and what forecast costs might look like into the future. Why are costs important? For NDRO, costs currently average 40-60% of gross proceeds (as reported in their regular quarterly reports).

"The Surprise (Dilution) Party"

Some trusts create sub-classes of units that receive an adjusted payout based on well performance. ECT, for example, subordinated 25% or the original units, such that they would receive a distribution only when the remaining units received a guaranteed payout. On one hand, this created near-term price insurance for the owners of non-subordinated units. On the other hand, it also meant that the quoted distribution for ECT units was given an artificial floor. Only if an investor had dove into SEC filings would s/he have noted that the subordination period was going to end and dilute the distribution.

"Intentional Bureaucracy"

Admittedly, I've been blasting the trusts for not sharing much information. However, in truth, trusts are little more than accounting shells that take whatever proceeds are given to it by the proprietor, process the necessary SEC paperwork, and issue the distribution (taking a healthy cut for themselves, of course). Although I compared buying a trust to buying a car, the trust is really a bureaucratic middleman-one who just wants to sell the car and doesn't care how well it runs. As I look at it, the apathy of the trust to actual performance creates a fantastic environment for a well proprietor to try to pass along whatever cost they can to the trust, even those that are not within the existing contract, because there is little to no incentive for the trust to push back.

Take HGT, for example. The well proprietor, XTO Energy (XTO), a subsidiary of Exxon Mobil (NYSE:XOM), was sued by a third party for inadequately compensating land owners on their royalties. XTO negotiated a settlement, and then passed 80% of the settled cost on to the trust ($28M). In this case, the trust sued back, deducting its legal fees from the distribution, and the case has gone to mediation. I'm not a lawyer and I have no knowledge of the legal merits of XTO or HGT's actions. But, it goes to show, that it takes a lot of money to get a trust to act-and even when it does, it comes at a cost to the unit holder.

If you dive into your favorite oil and gas trust's history of SEC filings and apply a critical eye, you will undoubtedly note other techniques that have been used to showcase positive information and sweep negative information out of the light of public consumption. The bottom line is: both well and trust proprietors seek to make money off of the investor and will act only in their best interest (and not in yours). Do your homework. You might even want to build a model of the trust to forecast future distributions. It's not to say that trusts are a bad investment, just that they might not be the best choice for bad investors!

Disclosure: I am long HGT. 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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