Chesapeake Granite Wash Trust (NYSE:CHKR) announced its third quarter results and declared its unit holder distribution on November 7th. The Trust continued to exhibit poor well performance, and additionally suffers from derivative contracts that worked against unit holders during the quarter. The quarterly results were well below the level forecast at the IPO of the Trust, and the prospects for improvement at present appear slim. The only question for existing or prospective unit holders is whether the current unit market price of $12.94 on the market close on 11/8/2013 is a good buy or a bad bet. This report will provide details for investors that will allow an informed decision to be made.
The CHKR quarterly distribution declared for production during the time period June through August 2013 was $0.6671 per unit. The distribution was 25% below target, and was so poor that the earnings on a fully dilutive basis could not cover the subordination threshold for the Trust. On a fully diluted basis earnings were $0.50 per unit, 44% below target. As a result, the subordinated units of the Trust (all held by Chesapeake Energy) received no distribution for the production during the quarter.
The lower distribution level is not a surprise, and unit holders should come to expect that this will be the new normal for the Trust. What may be a surprise this quarter, however, is that the Trust management declared in the earnings call that unit holders should now expect below threshold distributions throughout the time period until the subordinated units convert. The statement made in the earnings call was the following: "[addressing well performance issues] will most likely result in continued distributions to common unit holders below the subordination threshold in the future."
The price per unit of the Trust leading up to the distribution announcement was depressed having traded up to almost $15 per unit in mid October, only to trade down in late October to its present range below $13 per unit. The gap down was most likely in sympathy with the distribution announcements declared on several SandRidge Trusts on 10/24/2013. The decrease in market value of CHKR, however, was a valid market response to the expected continued performance issues faced by the Trust, and were verified by the CHKR distribution and earnings announcement.
Relative to its IPO projected distribution level, CHKR appears to be on a course for consistent (25%+) below target results near term, and even worse intermediate term as the subordination period expires in 2016. Below you will find an analysis of the trends and data, which point to this conclusion.
CHKR Earnings Performance Analysis
In the press release announcing the Trust results, management pointed to "lower sales volume and realized prices" than the estimate made at the Trust IPO as the reason that the distribution target was missed. Lower volume was not unexpected given the PV-10, which showed a sharp decrease in estimated MBOE proven reserves of -26.6% due to well performance. The well performance issue continues to plague the Trust, and Chesapeake Energy (NYSE:CHK) has slowed the pace of drilling on the remaining wells to give more time to assess the situation. Chesapeake is also drilling fewer wells per AMI in an attempt to increase well pressure and expected life on the remaining wells to be drilled.
During the 3rd quarter volume was 849 MBOE, down 12.3% from 968 MBOE in the summer production period in 2012 (current quarter distribution is for prior quarter production), and 3.6% lower than the 881 MBOE registered last quarter.
Distributable income for the most recent quarter was $23.4M, which is only 5.2% less than the earnings result a year ago. However, the graph above exhibits a non-linear relationship between production and earnings over the past year. The erratic correlation is attributed to price changes in the market and the derivative contracts held by the Trust. The 2012 results were plagued by a steep drop in natural gas prices driven by over-supply in the U.S. market. The energy boom driven by horizontal drilling increased market supply caused production to be scaled back on many projects and supply to be held off the market to cure the imbalance. As a result, many energy experts, including Boone Pickens, do not expect the price of gas to be able to rise substantially in the intermediate future due to oversupply and the resistance of U.S. energy policy to promote the use of natural gas for transportation. Nonetheless, increasing natural gas prices have affected Trust results positively over the past year.
In addition to the drop in production, the earnings level of the Trust showed an additional negative drag. The Trust posted a loss of $2.8M on derivative contracts related to oil and NGL production. The loss amounted to a 10.5% drop in income available for distribution. This issue will be reviewed in more detail in a section below.
In the graphic below you can see that drilling has been accelerated by Chesapeake ahead of the IPO schedule. Currently drilling is expected to be completed by the end of 2014.
Drilling completion by November 2014 means that subordinate shares will convert to common beginning with the February distribution in 2016. The IPO prospectus projected that the end of subordination could take as long as the June 2017 quarter.
The Trust has 37 wells remaining that Chesapeake is responsible to drill. The un-drilled wells represent 31% of the total wells the Trust expects to have in production when drilling is completed.
Recent Earnings Call Statement about Well Performance
Here is an excerpt from the Trust earnings call transcript dated 11/8/2013:
We are continuing to analyze the recent underperformance of certain wells in the Trust AMI. We have learned that the reservoir permeability and sand body continuity within the Colony Granite Wash reservoir are higher than expected, which has resulted in lower than predicted reservoir pressure in some development well locations. This has resulted in lower initial production rates and lower recoverable reserves, as well as a downward reserve revision to some older drilled wells.
During the quarter ended March 31, 2013, the Trust recognized a $32.9 million impairment of the Royalty Interest, and an additional impairment of $11.2 million during the quarter ended June 30, 2013, all due to the well performance issue. The write-offs represent 9.04% of the $487.8M Investment in the royalty interest made by the Trust at IPO.
The $44.1M write-off in book value of the Trust Investment is lower than the PV-10 downward adjustment on a relative basis. The 12/31/12 PV-10 reduced the proven reserves by 11,756 MBOE (26.3%) on a conveyance of 44,266 MBOE. On a relative basis, the write-off of the Trust investment is likely to eventually equal the PV-10 adjustment. However, it appears the Trust has only written off the degradation to proven reserves associated with the wells already in production - leaving future write-offs to be determined based on the results of the mitigation plan.
The mitigation plan announced by the Trust being pursued by Chesapeake is as follows:
With the goal of improving average well performance in the Granite Wash, Chesapeake reduced its rig count in the AMI from four rigs to two rigs mid-August 2013. We believe this slower rate of development is prudent and will provide the company more time to assess the performance of each new producing well bore and to optimize future well bore locations and intervals to be drilled. Because there are a finite number of wells remaining in the Trust to be drilled, Chesapeake's intent is to select the very best available locations at intervals in the Granite Wash formation.
The mitigation plan is intended to result in lower overall impairment realized by the Trust over the long term. In the near term it is likely, however, to mean continued lower distributions below the subordination threshold.
Production Mix Analysis
The PV-10 published in the most recent CHKR 10-K showed that the Trust over the past year showed a slight decline in oil in its production mix relative to natural gas and NGL. This product mix composition trend continued to be confirmed in the past quarter results:
The trend over time has impacted the value of the Trust as BOE volume has trended to lower value products. However, the impact in the most recent quarter due to production mix was not a major contributing factor on earnings performance.
Overall the composite average price realized by the Trust was little changed in the past quarter (-.53%), and was substantially higher by 19.3% over the prior year when gas prices were severely depressed. In the table below you can see the actual market prices for oil, gas and NGL during the past year and the last production period.
The average realized price at the Trust was $31.70 in the June through August production quarter.
Trust Derivative Position Analysis
The Chesapeake Granite Wash Trust has a majority of its liquid production hedged presently through December 2015 - which coincides very closely with the estimated time frame that subordination protection to common unit holders will end.
The bad news about the derivative position is that it is currently a negative drag on the Trust earnings potential as shown in the table above. Based on the forward pricing curve for WTI crude oil as of 11/5/2013 the estimated negative impact on Trust earnings through Q3 2015 is expected to be $(9.8M), or $(0.209) per unit.
The Trust does not hedge natural gas prices, and the general price improvement trend in the market has flowed through to the Trust's earnings in recent quarters. In the past production quarter as seen in the graph below, natural gas prices were a slight drag on the average price realized by the trust. The average price decrease in natural gas was made up by the increase in the price per barrel of oil - before the impact of the losses from the oil futures contracts.
The reason average prices remained stable in the prior quarter is due to the increase in sale price of oil to slightly more than $99. The 112 MBOE in oil production at CHKR in the last quarter was over 100% hedged with derivative contracts that lock the realized price after the impact from derivative contracts at $88 per barrel. Total futures contracts held by the Trust during last quarter were 187 MBOE, leaving an excess exposure to the hedge counter-party, which had to be covered with NGL production at a ratio of approximately 2 to 1. This contract structure only hedges general energy market price declines and does nothing for swings in the underlying NGL product market. As you can see in the graph, NGL market prices (not the delivery price experienced by CHKR) remained low relative to oil during the past production quarter. The spread differential of 2.6:1 over the past several quarters has placed a strain on realized NGL prices when the impacts of the hedges are included.
Here is the latest statement by the Trust CEO with regard to the NGL basis risk:
Turning to hedges, actual NYMEX oil prices were above the swap contract prices held by the Trust, resulting in a realized loss on oil contracts of approximately $2.8 million for the period. These fixed price oil swap contracts were initially established to hedge approximately 50% of projected oil and natural gas liquids volumes. The use of crude oil derivatives to partially mitigate the price risk of NGL production is subject to basis risk to the extent that oil and NGL prices are not highly correlated. The initial forecasted revenue for the Trust assumed an NGL price at 49% of WTI; actual NGL prices during the quarter were lower at 31% of WTI.
In the Trust 10-K published in early March, the year end PV-10 was supplied which showed a per share value of $9.47 for the cash flows expected to be generated from the sale of the remaining proven reserves held by the Trust, discounted at 10%.
The table above updates the PV-10 estimated value for the depleted production volume through August 2013. The adjusted PV-10 is $8.68 per unit share.
The 2012 PV-10 report utilized a delivered price level of $1.60 per MBOE for natural gas production. If the PV-10 per share is estimated using a market natural gas price of $4.12, which equates to a realized delivery price of approximately $2.84 for the Trust, the current adjusted reserve valuation is estimated to be $10.13 per unit.
Trust Fair Value Estimation
The PV-10 is a static price level valuation model of proven reserves. To incorporate the value of potential changes in price levels going forward, the gain in value afforded by the subordinate threshold protection as well as the degradation on unit value from the derivative contracts, it is necessary to use a discounted cash flow valuation model. The table below summarizes the assumptions in a model utilized to derive the valuation of a fixed termination date of a Royalty Trust like CHKR. The assumptions contained in the following table allow the creation of a go forward distribution forecast when combined with the expected depletion of remaining proven reserves held by the Trust.
(NGL projected price post hedge expiration includes the delivery differential)
The model price assumptions are based on the forward price curve as of 11/5/2013 for oil and gas prices combined with the Trust hedge contracts through 3Q 2015. The out year price levels are grown at a rate of 2.5% annually up to a cap level, which in this model are reached in 2029 for oil, but are not reached before Trust termination for natural gas. All prices are adjusted for delivery based on the average differential experienced by the Trust.
The model also uses a product mix as shown in the table, reflecting a downward adjustment in oil mix from the IPO distribution model.
When the price and mix assumptions are combined with the estimated proven reserves remaining at the Trust and the expected production curve, the distributions a unit holder can expect through the end of life of the Trust can be forecasted as shown in the graph below.
Through August of 2013, the Trust showed depletion of 23.8% of its proven reserves. Total remaining proven reserves are estimated at 25,838 MBOE as of the start of the September production period.
Based on this model, at the current price level of $12.53 on 11/07/2013 the implied rate of return on the Trust if bought and held to termination is 8.50%. A risk highlighted for potential investors in the above graph is the steep decline in distributions that common unit holders are presently facing when the subordination conversion happens, expected with the February distribution in 2016.
If you expect a 10% return on investment, a fair price level for a CHKR common unit is $11.80.
Because of the continued uncertainty surrounding the proven reserves associated with the AMI, and the resulting well performance issues, my fair market estimate at this time is $11.00 per unit.
In my article published in May 2013, CHKR was valued at $14.00 per unit. The lower valuation in this report reflects a reduction based on the distribution paid in May and August, and a downward adjustment reflecting continued well performance issues and the management signal that unit-holders should expect lower than threshold distributions going forward. The one change in market condition that would improve the value of the Trust, not associated with well performance, is NGL pricing relative to crude oil. A reduction in the crude oil / NGL spread would directly accrue to unit holders over the near term as the losses on derivative contracts would lessen.
Daniel Moore is the author of the recently published book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only.
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.