Chesapeake Granite Wash Trust Revisited

| About: Chesapeake Granite (CHKR)
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Last March I wrote my first bullish article on Cheaspeake Granite Wash Trust (NYSE:CHKR) that argued the shares (units) had been oversold, relative to likely future distributions. The trust had reported that its original estimated 44,000 MBOE of recoverable oil and gas Reserves had dropped by 10,000 MBOE due to the wells experiencing lower pressures than expected. In addition, since then the Reserves estimates have deteriorated further along with very disappointing production results. This last quarter the MBOE production declined 4% sequentially at a time when the increased well count should have caused production to increase, per the Trust's original projections. In sum, production volumes have seriously disappointed and the original MBOE production estimates should now be revised sharply downward through the life of the trust, which terminates in 2031.

The latest royalty distribution, for the quarter ending August 31st, was $.667 per common unit, failing to meet even the relatively "protected" subordination level of $.71 for the quarter. Had there been no protection [due to 25% of the units being subordinated, which are all parent owned by Chesapeake Energy (NYSE:CHK)] then the distribution would have been only $.50 compared to the threshold target of $.71. Worth noting, however, is that after backing out the net loss on hedging contracts, the minimum threshold distribution of $.71 per common unit would in fact have been achieved and paid. The pro forma distribution under a 'no subordination' scenario would have been $.55 sans hedging losses, which is a more accurate reflection of the Trust's earning power (at current hydrocarbon prices) than the reported $.50 after the derivatives' losses.

The thing about hedges is that some periods they make money and other times they lose. Thus, to project the current $.05 loss on hedges to every quarter in the future would be foolish and obviously too pessimistic. I prefer to project future cash flows assuming current hydrocarbon prices for all future quarters with no expected gains or losses from hedges, assuming these will roughly cancel out over time. Of course hydrocarbon prices could fall beyond hedge protection, jeopardizing my cash flow projections.

The Trust's average net prices realized for the quarter ending August 31st were $99.41 per barrel of oil, $30.97 per barrel of natural gas liquids and $2.51 per Mcf of natural gas. Oil was up $10.54 from the prior quarter while NGL and natural gas net realized prices were not much changed, lower by $0.46 per barrel and $0.14 per Mcf respectively. The trust's NGLs production for the quarter increased 10% sequentially while oil and natural gas volumes decreased 15% and 8% respectively.

The mix of production was 13% oil, 35% NGLs and 52% natural gas. Since oil has been a minor part of the output of CHKR, the hike in oil prices was not materially accretive to earnings. I have no geology expertise, but I wonder whether in the early years of well production it may be that lighter and less viscous gas & NGL components flow more readily, meaning that in subsequent years heavier oil would play a larger role in the mix? Perhaps an expert can weigh in on this question in the comments section. Regardless, it is safe to say that CHKR is largely a play on natural gas and NGLs prices. While prices remain low, there is always the risk they could go lower and hurt distributions. On the bright side, any gas or NGL price increases should boost future distributions.

What are the Shares Worth?

In a followup article that I wrote last April, I performed a detailed analysis in valuing CHKR units. While I did not nail down a precise share price, I did estimate the sum of future projected distributions as a proxy valuation. I did this in two parts: first, I summed my estimated distributions during the early years of high production with subordination protection (through approximately June of 2016) and second, I added some value for the low production later years from 2016 until termination in 2031. I viewed this second part as essentially the value of holding very long term call options on gas and oil prices. Potentially the late years' production could prove much more valuable than expected due to the 'call options' great time remaining until expiration. A lot could happen to hydrocarbon prices a decade or two out. In just the last 5 years, natural gas has ranged widely from as low as $2 to as high as $13 per Mcf. Currently it is approximately $4.50 per Mcf.

All the subordinated shares held by parent Chesapeake Energy legally get no royalty each quarter until the common shares have received the subordination threshold royalty for that quarter, which is stipulated in a table in the Trust's prospectus. This is true for each quarter until the subordinated units convert to common units once all the wells have been drilled, no earlier than June 2016.

In my April article I estimated an 85-90% chance that through the subordination period expected to end circa June 2016, distributions would meet or beat the $9.02 of aggregate remaining subordination thresholds provided for in the Trust's prospectus. I probably estimated those odds a bit too high as shareholders just got nicked this quarter, below the subordination level for the first time, with a $.667 distribution compared with the subordination threshold of $.71. The buffer provided by 25% of the units [the subordinated ones] receiving nothing did not quite fully protect the common units as I had expected. Further, future guidance from management is for likely future 'nicks' due to a slower pace in drilling new wells in order to better assess and maximize total future production:

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 is 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.

While we believe this moderated pace of drilling can ultimately improve the economic returns to the Trust, the operated rig count reduction will decrease the rate at which the royalty income from the remaining development wells becomes available to the trust for distribution. This will most likely result in continued distributions to common unit holders below the subordination threshold in the future.

As I noted, however, the last quarter's subordination threshold of $.71 actually would have been met had it not been for the derivatives loss of $.05. Given the vagaries of commodity price movements, it could have just as easily been a $.05 hedges gain for the quarter, in which case the net revenues could have been $.60 (without subordination) versus the $.50 reported. In other words, the pure MBOE production volume results were bad, but not quite as bad as the $.50 of net revenue would suggest. The mid point of $.55 (with neither a hedges gain nor loss) probably gives a fairer picture of future earnings power at current hydrocarbon prices. I will use this $.55 as a data point compared to original estimates in order to conservatively value the shares going forward.

This $.55 compared to the Trust prospectus' original $.71 projected for the quarter represents a realization of 77.5%. Applying this percentage to the remaining subordination threshold distribution estimates during the 'protected' subordination period through approximately June 2016 yields $5.37 in distributions. This $5.37 through June 2016 is an ultraconservative estimate. Why? Because it assumes no subordination protection when in fact there will be subordination protection. Recall that last quarter common unitholders were paid a royalty of $.67 even though the net revenues per unit were only $.50. The $.67 actually paid was 94% of the relatively 'protected' $.71 threshold while my projections use only 77.5% -- the estimated earnings power as if subordination didn't exist. Being ultraconservative in this case lops off $1.14 worth of distributions that would occur if the latest quarter's disappointing results were simply projected into the future ($6.51 versus $5.37, through June of 2016).

Presumably the drilling is completed and the subordination ends mid 2016, but in light of management having recently announced the halving of the drilling crews, it now seems likely that subordination protection will continue through as late as June of 2017. To be extra conservative, though, I'll allow just 65% of the original subordination thresholds rather than 77.5% for the four quarters from June 2016 through June 2017. This translates to another $1.05 in dividends through June 2017 for an extra conservative total projected distributions of $6.42 through then. After that, the subordinated units will have converted to common units and the protection thus ended.

However, quarterly royaties at some level will very likely continue through June 2031 -- another 56 quarters. My estimated, conservative 65% of the prospectus' subordinated threshold distribution in Q2 of 2017 is $.24. Reducing that by another 60% due to the declining production of old wells, as an average over the final 56 quarters, yields another $.096 per quarter, or $5.39 in eventual distributions, plus any termination dividend. Totaling all these conservative estimates gives $11.81 plus any termination value for the sale of the rights (which I do not feel can be estimated, so I will allow no value).

As a conservative valuation that is based on zero increases in oil or gas prices for 18 years, no techniques being successful in getting the wells to produce any better, and production disappointing even somewhat further than it has to date, I view this future estimated minimum cash flow accruing to shareholders of $11.81 as very attractive compared with the shares currently trading at $10.00. This is because even though the $11.81 represents a quite pessimistic scenario, you still get your money back! How many equity investments can boast a return of your capital even if things go badly?

On the other hand if hydrocarbon prices rise even modestly, or production does not taper as pessimistically as I have assumed, or there proves to be significant termination value, well over $20 in eventual distributions could easily be realized from a $10 investment made at the market price today. If natural gas prices rise substantially from the current relatively low price, that figure has headroom. Moreover, it is highly likely that the share price is near a bottom now and that a rising natural gas price would cause the market to bid the shares up fairly quickly. Even if it doesn't, the royalty income should rise in a rising gas price environment, compared with my current projections.

The beauty of it is that nearly $6.50 of your $10 is virtually assured to come back to you as royalties within a mere 3 1/2 years. (The figure arrived at by simply projecting last quarter's poor results would be even better at $8.03, i.e. simply 94% of the subordination thresholds through June 2017).

The Best Part: Call Options Included

After recouping at least ~$6.50 by June 2017, only ~$3.50 at most remains tied up, buying you some royalties from the diminished production plus in essence free 'call options' on the price of oil and gas for 14 more years. If my projected $.096 average royalty per quarter were to prove accurate, it would represent an annual yield of 10.97% on the $3.50 remaining investment. Not bad for a pessimistic scenario.

Understand that since the trust has virtually no expense drag to rise along with prices, higher hydrocarbon prices realized would translate to the bottom line slightly better than one for one. This is because the Trust has no employees, virtually no overhead, and its variable expenses are primarily based on volume of MBOE processed, not prices realized. Thus a 10% increase in realized prices would drive the bottom line (and royalties) by more than 10%. And this is without the use of any debt as the fulcrum of leverage.

Who is Selling?

The units are trading at all time low of around $9.90. I have argued above that such a price is a steal since roughly $6.50 in dividends at minimum is nearly assured within the next 3 1/2 years. There's also plenty of room for upside over the next 18 years and not a lot of downside. In the last week I have bought a large position at prices ranging from $10.59 to $9.95.

I had sold most of my CHKR overweight months ago when it spiked to the $15 range, keeping just a small position until last week presented this tremendous buying opportunity. The question of course is why is there so much selling as to drive down the price? Could the sellers be the smart ones?

I argue above that the downside from here is very small in that a buyer in the $10 range should at the minimum receive all of his investment back in dividends over time, perhaps far more. I believe my arguments are sound and I back them with my wallet. I view the sellers at these prices to be making a mistake. But why?

Likely three factors are pushing the share price down into silly territory. First, this is tax loss selling season. Big share-price losers tend to get sold in December in order to offset gains for minimizing current year taxes. Since most stocks had handsome gains in 2013, investors looking to sell losers for the writeoffs have but few choices in their portfolios. Certain oil & gas royalty trusts are among the big losers in 2013.

Second, CHKRs production volumes have seriously disappointed and recoverable Reserves are surely much lower than originally estimated. For some investors this casts doubts on management and they just want out. They don't trust any projections any more. Personally, I don't think anybody, including geologists, can say how much wells will produce until after they are drilled, especially since hydraulic fracturing and horizontal drilling are fairly new techniques. But my use of just 65% to 77.5% of the original subordination threshold minimum distributions provides for a margin of safety should drilling results and/or realized prices continue to disappoint further.

Finally, CHKR shares have been trading an average daily volume of just 230,000 shares. If multiple institutional owners are trying to get this 'loser' off their books for year end 'window dressing', such institutional selling, which tends to be indiscriminate of price, could explain the recent relentless pressure on the shares given the relatively illiquid market. Dumping a $5 million position might require all of the volume of a couple days of trading. Price gets very pressured in such situations.

My recommendation is to buy CHKR now at anything below $11.00 and really back up the truck at below $10.00. I think it is highly likely the shares will spring back sharply from their lows in early 2014, after the year-end selling has abated. The so-called "January effect" could be turbo charged for CHKR since it is so cheap relative to its royalty stream to come. By holding for a few months into 2014, the share price should rise along with receiving a February royalty dividend of at least $.50-$.60. It's highly likely that buyers at ~$10 now will be able to sell for a double digit total return within a mere 1-4 months, and I'm not talking about annualized return! It's just my kind of trade.

Disclosure: I am long CHKR. 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.