Chesapeake Granite Wash Trust Still Overvalued

| About: Chesapeake Granite (CHKR)
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The Trust has numerous issues that greatly increase the risk that isn't properly compensated for at current prices. The Trust is currently at least 24% overvalued, and possibly more if investors adjust their desired rate of return from the initially targeted rate of return. Investors are basically playing the BTU spread convergence (1 barrel of oil = 6 mmbtu of natural gas in energy output terms) while production declines at a fast rate.

Overview of Trust

Chesapeake Granite Wash Trust (NYSE:CHKR) that allows unit holders to receive proceeds attributed to the royalty interest of a collection of wells controlled by Chesapeake Energy Corporation (NYSE:CHK). The wells target the Oklahoma Colony Granite Wash formation located between 11,500 feet to 13,000 feet below the surface. The wells produce out of a condensate gas reservoir, giving unit holders exposure to about 15% oil, 35% NGL and 50% natural gas production. The Trust receives 90% of Chesapeake's proceeds on 69 producing wells with an average 4,100 feet per well of productive zone at the inception of the trust. Chesapeake has an obligation to drill and complete 118 development wells with an average of 3,500 feet per well of productive zone which the Trust will receive 50% of Chesapeake's proceeds. Chesapeake must complete all wells by June 30, 2016, and had stated in the prospectus they would shoot for mid 2015. Note: I adjust the 69 producing wells into 145.5 wells so they are equivalent to the 118 development wells => 69 * (4,100 / 3,500) * (90% / 50%).

Things haven't quite gone as planned and the Trust units' market value and distributions have suffered. Reasons for this underperformance include: 1) lower than expected NGL and natural gas prices, 2) over hedging oil production and a failed attempt to hedge NGL prices due to basis risk, and 3) the largest impact is declining reservoir pressure which is impacting production volumes.

Distributions to Date and NPV of Trust

Let's gain prospective on the Trust's future by taking a look at the current price and the expected net present value of the remaining target distributions. The Trust closed at $10.72 a unit on 1/2/2014. If things had gone according to plan, the remaining target distributions would make a trust unit equal to $15.82. The IPO was priced out at $19, which gave the units a 9% return based on target distributions, so all NPV calculations will use this rate. The Trust has a subordinate threshold at 80% of the target distribution. Chesapeake holds 25% of the Trust units as subordinate units, distributions from these units will be given to normal Trust holders to cover the difference. If the quarterly distribution falls below 60% of the target distribution, the subordinate units get nothing. Assuming quarterly distributions were 70% (this is the average distribution that the Trust has earned since Q1 2012 before subordinate adjustments) under the target threshold for the life of the trust, the NPV of the units would be from $11.97 to $12.11 (depends on drilling schedule, which determines end of subordination units). Below is a history of distributions so far:

The subordinate threshold was broken in the most recently reported, Q3 2013. The distribution was 56% of the target distribution, if all future distributions were initially 56% below the target threshold, the unit NPV@9% would be from $10.46 to $10.73. Assuming the Trust can maintain distributions at 56% of the initial target, the Trust units are fairly valued. I would argue that with such underperformance to date, the 9% return rate doesn't compensate investors for the inherent risk that this Trust has to offer.

Historical Pricing

The first proverbial shoe to drop for the Trust was NGL and natural gas prices falling below Chesapeake's forecasted prices. The chart below represents the Trust's realized sales prices versus EIA reported spot prices during the respective production period for each quarterly distribution. For Q4 2013, I use the quarter over quarter change in EIA prices to project the Trust prices they will report. This is a good method for oil and natural gas, but NGL prices for the Trust do not reliably track (but the best option I have) Mont Belvieu Propane prices (NGL is composed of ethane, propane, butane, isobutene and natural gasoline, but we do not know the Trust's NGL composition).

Trust is Speculatively Short Oil

Chesapeake used the NYMEX forward curves for oil and natural gas until June 2014, and then assumes prices will rise at 2.5% annually capped at $120/bbl for oil and $7 mmbtu for natural gas. NGLs are assumed to trade at a 49.2% discount to oil. The Trust hedged 50% of their oil and NGL production until Q3 2015. Natural gas was left completely unhedged. With projected oil production being roughly half the volume of NGL production, this equates into effectively a 100% hedge on future oil production volumes. With NGL and natural gas being left unhedged. The basis risk the Trust held between the NGL and oil soon moved against them. Oil prices went up and NGL prices dropped.

The hedging issue does more than cap the Trust's potential proceeds from higher oil prices. Due to lower than anticipated production, oil is now over hedged, and with NGL prices not correlating to oil prices, there is no offset to this over hedge. In last quarter, the trust produced 112,000 barrels of oil, but had outstanding contracts for 188,000 barrels of oil. Basically the Trust had a 76,000 barrel speculative short oil position that resulted in a loss of $1.121M to unit holders, or $14.75 per barrel. The chart below shows the potential effect of the speculative short position depending on if NGL prices ended up moving with oil or were unaffected. With historical NGL pricing history, the blue line is the more likely outcome:

Clearly, the speculative short position is more of a minor drag on the Trust, only reducing last quarter distributions by $0.024. However, there are also issues with declining reservoir pressure. The Trust is producing a condensate gas reservoir. When reservoir pressure is above the dewpoint line, the condensates (aka NGLs) and oil are in vapor form like the natural gas. Once the pressure drops below the dewpoint, these heavier components condense (oil being the heaviest and most valuable) in the wellbore and reservoir, failing to be produced. That is why since 2008, the percentage of oil produced has been fallen from 21% to 13%. Eventually, these condensates can even reduce the gas permeability of the formation near the wellbore and impact natural gas production rates. The chart below shows the percentage of oil, NGL and natural gas production since 2008:

Declining Reservoir Pressure Effect on Production

Not only is the declining reservoir pressure affecting the composition of the Trust's production. It is also the reason why BOE production has fallen 20% from the high point in Q2 2012 to the most recent quarter. The Trust prospectus had forecasted that peak production was supposed to occur sometime around last quarter and then gradually fall off until a steeper drop off in 2016 after the completion of the 118 development wells. The prospectus had forecasted BOE production levels as shown below:

Instead, the level of production in the last quarter is around 22% lower than expected. Definitely not the peak production period the prospectus had implied. On top of the declining percentage of production being oil, overall production is on the downward slide, too. That speculative short oil position is only going to get bigger until the "hedging" program ends in Q3 2015. The chart below will show what the trust has done versus what was expected:

Future Production Forecast and Pricing

What's the future of the Trust? As a result of underwhelming production numbers by the Trust in the past year, Chesapeake first decided to reduce the density of wells per section from 4 to 3 in May 2013. Probably because the drainage area of each new well interferred with older neighboring wells, due to higher permeability of the formation. This would result in lower initial production in the new well, and steepening the decline rate of the older well when it should be flattening out.

In Aug 2013, they reduced the rig count from 4 rigs to 2 rigs to buy more time to figure out what to do and noted that in Q4 2013, this would result in the subordinate threshold being broken. I believe Chesapeake has conceded defeat on this Trust. Chesapeake has other opportunities its rigs would be better utilized on, and focusing scarce capital on a failed investment (the subordinate units aren't earning anything for them) might not in their shareholders best interest. All they need to do is meet the June 30, 2016 deadline for the 118 wells to be drilled. Two rigs drilling about 4 wells a quarter for the next 11 quarters fulfills that requirement.

The lower drilling actively will result in production numbers declining even faster than they have so far. Hydraulically fractured wells tend to have a huge initial burst of production that falls off rapidly during the first year. The 2011 10K (page 47) had projected all currently producing properties would decline at an annual rate of 33% during the first year. The 2012 10K (page 17) stipulated the same thing, but the rate was now projected to be 35%. That means, the 29 wells that they drilled in 2013 were supposed to replace that 35% drop in production and plus some. We can clearly see, this didn't happen! With the Trust only bringing on 16 new wells next year, we can expect significantly lower production next year, too. Note: Some information on decline rates for hydraulically fractured wells overall and Chesapeake's wells can be found at the links.

Unfortunately for investors, nobody knows how hydraulically fractured wells will operate in 10 plus years. But when we consider that older wells' decline curves have been negatively impacted to date, and newer production won't be coming on at such a high rate. I modeled out future production based on decaying the average per well daily production rate on a quarterly basis. It is a relatively simple method, but I found it would otherwise require too many assumptions to attempt to model out decline rates of different phases of wells and match to past production. Below are the annual results to show what I did to build out the production rates going forward for the trust:

The red is the historical results so far and green is future projections. I assumed that average per well production would fall at 8% a quarter (72% annually) until the drilling program is completed, which is the average rate since the trust has been trading (the annual numbers don't quite reflect the quarterly numbers because AvgDaily are linear averages of a geometric progression). Some might argue that the growing number of older wells with lower decline rates should reduce the decline rate during 2014 to 2017. I decided to use the same average decline rate as reported during 2011-2013 quarters since the older well decline rates are being negatively impacted by the new wells, hydraulically fractured wells annual rates decline over 25% during the first 4 years, and the lower level of new production (Did Chesapeake drill the best sites first?). After 2016, I bring the decay rate gradually back to the prospectuses assumption of 9% annually and above that after 2025. But anything beyond 5 years really has little effect on the Trust's NPV since 70% of the value is composed of the first 5 years. The chart below shows how my forecast stacks up against the Trust's prospectus forecast:

The next two variables to model out the NPV is production composition and pricing. For pricing, we already know what spot prices were for oil and natural gas plus historical discounts to the Trust in Q4 2013. I assume half the rise in propane prices for the NGL component will flow through, too. Q4 2013 prices will be near $97.18 for oil, $34 for NGLs, and $2.53 for natural gas. I assume oil will rise annually at 2% (inflation) until it hits a $120 cap (as the prospectus assumes) out to 2031. NGLs will be $36.25 (half of continued increase in propane prices through January) and flat until 2031, since inflation and the higher content of lighter NGLs in the future should cancel each other out. Natural gas is adjusted upward to $3.21 to represent the appreciation of prices since December and will rise 2% annually for inflation. I do not use NYMEX curves, since those are forward curves which reflect time value of money, storage cost and convenience yield, or the overall structure of those markets and not a forecast.

Production composition I believe we will continue to see an annual decline of 8% in oil composition of total production and NGLs will decline around 2% annually (different NGLs will fall out at different reservoir pressures). Natural gas will eventually be 70% of the production mix in 2031, as shown in the following chart:

Projected Q4 2013 Results

For Q4 2013, we can expect to see 792 mBOE in production. Giving us $21,693 for distributions, or $0.464 per unit. Unit holders will get $0.6187 and the subordinate units will get nothing again. Details below:

NPV of Trust

With the assumptions laid out above, the NPV@9% of the Trust would be $8.17. From Friday's closing at $10.72, that would make the trust 24% overvalued currently. And with investors consistently running up the price of these oil and gas royalty trust before the ex-dividend date, the potential return from shorting this asset can be even better.

But the current premium is actually probably a lot greater than 24%. With such a history of negative performance, investors should be seeking a higher rate of return than 9%. From a growing short oil position (model had just under $20M in hedging loses over next 2 years, if oil export ban is lifted this will get a lot worse) which leaves investors hoping for an unlikely convergence of the BTU spread to the fact Chesapeake is still "analyzing" how to maximize production. Below is a table that shows the different NPVs for different desired rate of returns, and how much is reflected in the next 5 years of distributions:

The trust is currently trading at around a 3.6% rate of return, but considering the history of the Trust, maybe investors should seek an 11% to 13% rate of return. Clearly, if quarterly production volumes continue to decline at the rate that they have so far, current investors are in for significantly more pain and disappointment.

The real opportunity to short this stock, is before the release of the 10K in March. The 10K will come with a new reserve estimates for the Trust, which will present the short trader with an excellent catalyst. With the trust taking two impairments to the balance sheet over 2013 of $44M to its $488M Investments in Royalty Interest, we can expect to see revisions to the reserve reports in the 10K.

Side Note: The Natural Gas Play

Natural gas and NGLs (especially ethane) has been extremely beaten up over the past couple years. The current winter has been fairly cold and is doing a good job at working off inventories like we haven't seen in years. Many are tempted to use this Trust as a way to play the current rise in natural gas and NGLs. While I do believe long term demand will catch up with supply, it always does, that won't happen for several years. Currently inventory drawdowns is purely seasonal, LNG export terminals is limited and numerous postponed production and gathering system projects could easily be dusted off if prices rise a little. Oil has much better fundamentals, yet the Trust is short oil.

Despite my doubt on natural gas prices rising too much in the near term, even if they did, the Trust is the wrong vehicle to make that play. The investor would be better off finding a company or trust that is currently barely profitable or breaking even. The Trust only loses just over a dollar per mmbtu on the natural gas that it sells. If natural gas goes from $3.50 to $4.50, profits from natural gas increase less than 50%. While a company that is breaking even or making a small profit will notice significantly larger profit jump of multiples greater than it was making before. It would take a $7.70 ($6.50 after discounts to the Trust, double my assumptions) natural gas price for my model to give a NPV@9% value of $10.72 for this Trust. The optionality of this trust is more like a covered call than an outright call option. The investor maintains most of the downside risk, but caps their upside potential.

Disclosure: I am short 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.