SandRidge Permian Trust (NYSE:PER) provided an updated PV-10 report in its 10-K published on February 28, 2014. This article augments information provided in the on-going series of reports on the Trust performance since its IPO.
The most recent PV-10 at SandRidge Permian Trust showed a standardized measure drop from $13.39 to $11.16 per unit. When underlying production of 1,515 MBOE in 2013 is taken into account and a generally favorable product pricing compared to 2012, the downward adjustment is a harsh, but probably not totally unexpected, result by the market. A big component in the drop is shown in the graph below, a 2,192 MBOE downward adjustment in proven reserves estimated to be recoverable by the Trust. This is a 10.2% reduction if you look at the number from the perspective of the proven reserve estimate of 21,559 provided as an estimate to new investors at the IPO of the Trust. Overall if you account for discoveries and downward revisions the Trust currently has 16.9% less in estimated reserves than were projected at the IPO.
Since the definition of proven reserves is intended to be an educated estimate with at least 90% confidence, there is a definite element of buyer beware in play when it comes to accepting the estimates provided by E&P operators in need of capital. But there also appears to be a more systemic market issue in play. In following the production and drilling results of multiple trusts launched in the 2011 timeframe, empirically the results are outliers to the downside of original estimates by a large margin. Whether the Trust properties are located in the Mississippian (NYSE:SDR) (NYSE:SDT) (NYSE:SD), the Permian or Granite Wash (NYSE:CHKR) (NYSE:CHK) or the Marcellus (ECT), each has experienced "well performance" issues according to the operators. Based on the on-going review, it is becoming clearer that the issue is technology and feasibility of recovering the full potential of estimated reserves at a reasonable cost using horizontal drilling technology. A recent article published by Bloomberg News entitled Dream of US Oil Independence Slams Against Shale Costs provides very good insight into the challenges being faced in the industry today.
The table below provides additional information on the market pricing and trend in the absolute level of the PV-10 standardized measurement.
If there is any good news in the report, it is that the liquid portion of the production is expected to remain stable at over 95% of the product mix, with crude oil at 86% of the total. Additionally, the PV-10 was calculated using a $32.10 NGL price level, which significantly improved over the harsh winter experience in the Midwest and east coast, and may return to its more typical level of about 50% of crude oil in terms of market price.
Distribution Trend Reflects Lower Reserve Output
PER's common unit distribution of $0.64 on February 28, 2014 for the fall of 2013 production period was 12.3% below target. Overall earnings on a fully dilutive basis covered the subordination threshold for the Trust, and both the common and subordinate unit-holders received the same distribution amount.
As the above graph shows, PER's distribution levels stabilized quarter over quarter, having risen substantially in August and November. The increase in the summer months was attributed primarily to the narrowing WTI-WTS differential. In the latest quarter the differential was in a more favorable range, and ended the period in a more typical range.
Given the lower level of potential reserves, SandRidge is maintaining the above threshold results by keeping an aggressive drilling schedule, replacing lost tail end production on the front end by putting wells into production faster. SandRidge's drilling obligation is expected to be fulfilled by November 2014 and the subordination threshold for investors is expected to expire in November 2015.
The good news for investors is that the threshold minimum is very likely to be coverable based on the expected production levels through 2015, providing 7 remaining distributions at $.60 / unit or above. However, once the threshold is reached, the Trust distribution level can be expected to drop, most likely below $.40 / unit, and fall steadily thereafter.
Energy Price Curve Favorable Short Term
Energy price levels in the current market reflect a combination of the prolonged cold winter experienced by the Midwest and East coast of the U.S., and more recently the geopolitical risk raised by the Ukraine siege by Russia. In the February distribution provided by the Permian Trust for the August thru November production period, the realized average price level was $91.05 per MBOE. Realized price levels were considered to be strong, augmented by a tight WTI-WTS spread which allowed a high realized price level against the $101 WTI derivative contracts. NGL prices in the distribution quarter were still low, but improving. Natural gas prices had not yet spiked due to the winter weather.
In the upcoming quarter oil prices are expected, based on already known market price levels to remain favorable to results. In addition, unit holders can expect some benefit from the increases in price levels in the NGL and natural gas market. However, the total contribution to price from these products is not high, as NGL is only 9% and natural gas is less than 5% of production volume.
The bigger issue owners of Permian Trust units face is the market direction for crude oil. The recent Ukraine crisis buoyed the bid for crude oil even in a well supplied U.S. market. Public reports state that Russia and other oil rich nations increasingly need oil price levels in excess of $100 per barrel to sustain their economic growth. Meanwhile, the U.S. futures curve is pointing to a decline to the $80 range and even below in 2016 and beyond.
Where will market prices for oil actually gravitate? My opinion is that the NYMEX futures curve is biased to the downside by those involved in the trade, and the actual results will be far different from what is being projected. As the evidence mounts that even the U.S. cannot support oil exploration with price levels below $100 per barrel, which empirically I am seeing in the numbers, I expect the game to eventually change. The current low forward curve is likely hampering capital formation to actually deliver the oil volume required to keep price levels in this range. But the futures market is like ESPN Game Day; it attracts attention and a betting line based on opinions is formed. However, very often futures markets are skewed to the biases of the individuals who are tuned in, and the actual results end up being far different than the pre-game bravado.
Trust Fair Value Estimation using Updated Proven Reserve Report
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, as well as the value of the derivative contracts and the subordination threshold protection for common unit holders, it is necessary to use a discounted cash flow valuation model. The information contained below is based on a valuation model utilized to evaluate the fair market value of fixed termination date Royalty Trusts like PER.
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.
The product price level assumptions in the model are derived from the current NYMEX forward price curve for crude oil and gas combined with the Trust hedge contracts in place for crude oil thru March 2015. Since the price level of oil is such a critical component in determining the fair value of the Permian Trust units, the following graph has been created to help investors visualize the current expectation for crude oil prices over the next 5 years.
With the expiration of the SWAP contracts on the books at the Permian Trust in March 2015, currently the futures market is projecting price levels in the $90 range declining steadily into the $80 range further into the future. If these expectations materialize, the Trust faces a gap down in earnings power in the spring of 2015. However, as I stated above, my personal opinion is that WTI price levels on average are more likely to actually remain at the level they are currently, and even rise. However, to derive a fundamental fair value estimate, I have utilized the aggregate market price expectations at the present time.
All prices in the valuation model are adjusted for delivery based on the average differential which is typically realized by the Trust. Although the delivery differential on WTI-WTS narrowed substantially in 2013 and averaged $2.99 from March through November, the historical average rounded up to $6.00 is utilized as an assumption in the model.
The model uses a product mix of 86.1% oil, 9.3% NGL and 4.5% gas. This production mix is the same as the Trust PV-10.
When the price and mix assumptions are combined with the current 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 forecasts as shown in the graph below (see the blue line).
Through November of 2013, the Trust showed depletion of 21.44% of its proven reserves. Total remaining proven reserves are estimated at 14,005 MBOE as of the start of the December production period.
Based on this model, at the current price level of $12.79 on 3/05/2014 the implied rate of return on the Trust if bought and held to termination is 8.00%.
If you expect a 10% return, a fair price level for a PER common unit is $11.60.
Based on the Trust continuing to exhibit solid results, my fair market estimate at this time is adjusted downward to $12. This value estimate is a $1 reduction from the $13 range in my previous report, and is based on, in my opinion, a worse than expected updated PV-10.
The current price level of Permian at $12.79 as of 3/5/2014 is above the model valuation level at a 10% discount level. The price level is considered fair relative to other fixed income market alternatives in the current low interest rate environment. Likewise the present traded market price reflects an expectation for low oil prices going forward after the expiration of Trust derivatives (assuming no additional major reserve adjustment downward). Just as an information point, should oil prices turn out to be $100 and above after the Trust derivatives expire, the 10% discounted cash flow value of the Trust is $14.25. Expectations do make a market interesting.
Daniel Moore is the author of the book Theory of Financial Relativity: Investment Portfolio Guidance in a Federal Reserve Driven Bubble Prone Deflationary Era. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I am long PER, SDR. 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.