On March 14, 2014 Chesapeake Granite Wash Trust (NYSE:CHKR) published its 10-K report which contained an updated standardized measure of proven reserves (PV-10). The updated report showed continued very poor drilling results. As shown in the table below, the total reported net reduction in proven reserves since the IPO of the Trust in July of 2011 is 16,329 MBOE, a whopping 36.9% of the estimated reserve level presented by Chesapeake (NYSE:CHK) to potential unit holders when capital was being raised to fund the Trust.
The PV-10 standardized measure per unit as of 12/31/2013 fell to $6.78. On March 14, 2014 the Trust units were trading at a value of $11 on the NYSE, a full 1.62 times the PV-10. This valuation level is well above any reasonable fair value assessment of the Trust units given the new reserve data and the miserable track record of Chesapeake as an operator.
Distribution Trend Reflects Proven Reserve "Wipe Out"
Chesapeake Granite Wash Trust announced its 4th quarter results and declared its unit holder distribution on February 7th, 2014. The Trust continued to exhibit poor well performance, and additionally suffered 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 were portrayed as unlikely. The only question for existing or prospective unit holders is whether the current unit market price of $11.00 as of the market close on 3/14/14 is a fair value.
The CHKR quarterly distribution declared for production during the time period September through November 2013 was $0.69 per unit. The distribution was 23% below target, and on a fully dilutive basis, earnings did not cover the subordination threshold for the Trust. Earnings were $0.4968 per unit, 42.2% 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. Trust management has previously declared that unit holders should expect below threshold distributions throughout the time period until the subordinated units convert.
Relative to its IPO projected distribution level, CHKR appears to be on a course for consistent (30%) + 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. Well performance issues continue to plague the Trust, and Chesapeake Energy 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. However, even with this plan being put into action during 2013, the Trust still recorded a reduction of proven reserves of 6,220 MBOE per the most recent PV-10, a very poor indication of any progress. For reference, the recorded reduction in 2012 was 9,975 MBOE.
During the most recent quarter, volume was 809 MBOE, down 18.3% from 990 MBOE in the fall production period in 2012 (current quarter distribution is for prior quarter production), and 4.7% lower than the 849 MBOE registered last quarter.
Distributable income for the most recent quarter was $23.2M, which is 16.2% less than the earnings result a year ago. 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. With the harsh winter in the Midwest and on the East Coast, prices for natural gas and NGL products have recovered to levels not experienced for several years. The increase in natural gas prices, however, was not evident in the fall production period. Benefits from price level increases are expected to be realized in the next Trust distribution.
In addition to the drop in production, which negatively affected the Trust, derivative contracts continue to constrain distribution potential for unit holders. The Trust posted a loss of $2.265M on derivative contracts related to oil and NGL production. The loss amounted to a 9.8% drop 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, although in recent quarters the pace has slowed from the level in 2012. Currently drilling is expected to be completed by the end of 2014.
Drilling completion by Nov-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.
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. Although the expectation given the information in the PV-10 report is that remaining oil reserves comprise only 11% of proven reserves, and oil production currently is running higher than this amount. This means that the more valuable oil resources owned by the Trust are being depleted quicker than the less valuable gas products.
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. In fact, a slightly higher percentage of oil production helped earnings to remain flat relative to the past quarter even though production declined by 40 MBOE.
Overall the composite average price realized by the Trust improved by 2.67%, and was higher by 9.4% over the prior year when the Trust realized gas price was below $2 per mcf. 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 $32.56 in the September through November production quarter, with NGL price levels contributing most to the improvement in realized price levels.
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 timeframe 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 as of 11/5/2013 the estimated negative impact on Trust earnings through Q3 2015 is $(8.9M), or $(0.19) 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; however, the gas price improvement does not contribute as much as investors might expect because the Trust pays a very high differential for the delivery of gas products. 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 NGL price levels - before the impact of the losses from the oil futures contracts.
The reason average prices increased in the most recent quarter is due to the increase in NGL market price levels (using Propane as a proxy) from around $40 to almost $50 per BOE. The 115 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. Total NGL production during the quarter was 280 MBOE. The spread differential narrowing to 2:1 during the production quarter was favorable for Trust earnings during the quarter, and also helped to decrease the losses experienced on derivative contracts quarter over quarter. In the summer of 2013 production quarter (May-August in the above graph), derivative losses were $2.8M.
In the Trust 10-K published in on March 14, 2014, the year end PV-10 was supplied which showed a per share value of $6.78 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 below reflects the yearly erosion of the PV-10 due to depletion, change in price levels used in the computation and the reduction in reserves due to ongoing well performance issues. Since July 2011, only 9,435 MBOE of the 25,764 reduction in MBOE since the Trust IPO can be attributed to actual production. In total, Trust production accounts for 21.3% of the proven reserve decline since IPO, while well performance related reductions account for 36.9% of the reduction relative to the IPO estimate.
Overall price changes in the PV-10 were more favorable than in 2012 for oil and natural gas, while NGL prices were lower. The 2013 PV-10 report utilized a delivered price level of $2.36 per MBOE for natural gas production, which was an improvement from the $1.60 used in the calculation in 2012. NGL pricing used in the PV-10, on the other hand, was reduced to $31.86 from $33.22 in 2012. Expectations are that NGL price levels will likely recover to the historical 50% of crude price levels through time, particularly once NGL exports begin to increase.
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 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.
The model price assumptions are based on the forward price curve as of early March 2014 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 ($14.46) can be forecasted as shown in the graph below.
Through the February 2014 distribution, the Trust showed depletion of 32.6% of its proven reserves. Total remaining proven reserves are estimated at 18,502 MBOE per the 12/31/2013 Trust PV-10.
Based on this model, at the current price level of $11.00 on 3/14/2014, the implied rate of return on the Trust if bought and held to termination is a meager 4.32%. This rate of return is considered too low given the continued high risk faced by CHKR in recovering the actual proven reserves due to continued well performance issues. As shown in the graph above (see blue line), and highlighted by Trust management, CHKR is very unlikely to be able to meet target threshold distributions through the time period in which the subordinated unit holders convert. This expectation is reflected in the continued decline in unit distributions through 2016. In addition, once the subordinated units do convert, distribution levels can be expected to drop even further. In the model, at the expected conversion date, distributions per unit are expected to be below $.30 per unit.
If you expect a 10% return on investment, a fair price level for a CHKR common unit is $8.37.
Because of the continued uncertainty surrounding the proven reserves associated with the CHKR AMI, and the resulting well performance issues, my fair market estimate at this time is $7.00 per unit, which is essentially equal to the current PV-10. This is a dramatic reduction from the current Trust traded value in the market. If you are not currently in the units, my advice is to stay away. If you have positions, there are better places to put your money. At a 4.32% implied rate of return, you would do better investing in 30 year U.S. Treasuries on a risk adjusted basis. At least in the case of Treasuries you are virtually assured of getting your money back.
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 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.