For the second year in a row, a major downward reserve adjustment was recorded at the SandRidge Mississippian Trust I (NYSE:SDT). On March 14, 2014, the Trust published its 10-K report, which contained an updated standardized measure of proven reserves (PV-10). The updated report showed continued deterioration in reserves due to poor well performance. As shown in the table below, the total reported net reduction in proven reserves since the IPO of the Trust in April of 2011 is 4,874 MBOE, a loss of 25.7% of the estimated reserve level presented by SandRidge Energy (NYSE:SD) to potential unitholders when capital was being raised to fund the Trust.
But the loss of reserves is not the only issue plaguing the Trust. Performance is also hindered by the change in the mix of resources being recovered or expected to be recovered in the future. Initially, the Trust was portrayed as having an oil/gas mix of 48/52. Through time, the PV-10 report has been adjusted to reflect the reality that the Trust will deliver far less oil than expected, instead delivering a higher concentration of far less valuable natural gas. Additionally, the initial reserve reports (IPO and 2011) showed no indication of NGL in the production, thus making the 2012 report downward adjustments very steep, as the mix change was introduced to investors along with well performance reductions. As of 12/31/2013, the reported reserve mix expected for the remaining life of the Trust is 22/20/58, oil/NGL/Natural Gas.
The PV-10 standardized measure per unit as of 12/31/2013 fell to $6.23. On March 14, 2014, the Trust units were trading at a value of $7.64 on the NYSE, 1.22 times the PV-10. The price level of the units traded down sharply throughout 2013 and early 2014 as market participants adjusted expectations to the reality that the Trust was far less valuable than portrayed in its initial SEC filings. The remainder of this report will focus on the current reported performance of the Trust to provide information about whether the current traded unit value is reasonable investment, or remains a "pig in a poke".
Quarterly Distribution Downward Trend in 2013 Signaled PV-10 Adjustment
The recently reported quarterly results by SandRidge Mississippian Trust I showed a continuation of deteriorating production volume and poor earnings performance. On January 30th, SDT announced its quarterly distribution for production during the time period of September through November 2013. During the fall, the energy market showed relatively high oil prices throughout, but weaker natural gas as oversupply in the market continued. NGL prices began to improve during the period. Major improvements in natural gas and NGL prices are expected to be exhibited in the results that will be announced in the winter quarter (May distribution).
In the context of a generally healthy energy market, SDT's common unit distribution of $0.50 was 34.2% below target. Overall, earnings on a fully dilutive basis, for the 4th quarter in a row, could not cover the subordination threshold for the Trust, leaving the common units with a lower than threshold distribution. Subordinated unitholders continued to receive no distribution at all.
As the above graph shows, SDT's distribution level showed a steep decline in the recent quarter. The severity of the decline is particularly troubling because the common unitholders continue to be protected by a subordination threshold that will expire after the next distribution.
The Trust press release references lower sales volumes as the cause for the miss. This statement is made relative to the Trust IPO prospectus, which projected a higher overall MBOE production volume in both crude oil and natural gas than was eventually discovered. SDT is on a course for constant (30%)+ below-target results near-term, and even worse intermediate-term performance relative to its IPO distribution target levels, as the subordination period expires in 2014.
SDT Earnings Performance Analysis
In the press release announcing the latest Trust results, management pointed to "lower oil sales volume" than the estimate in the IPO prospectus as the reason that the distribution target was missed. The PV-10 released on 3/14/2014 in the Trust 10-K showed a continued decrease in MBOE proven reserves of -21.3% (year-over-year) during 2013 due to well performance. The degradation in results was exacerbated by a shift in product mix from 25% oil to 22% oil expected in the future. The quickening pace of loss of oil production is to some extent a by-product of horizontal drilling. The output of shale wells drops faster too, falling by 60 to 70 percent in the first year alone, according to Austin, Texas-based Drillinginfo Inc. Traditional wells take two years to fall by about 55 percent, before flattening out. SDT has no more wells which are being drilled; therefore, oil production loss can be expected to remain particularly acute in the coming quarters.
During the last quarter, production volume was 244 MBOE, 17.5% lower than production in the June-August quarter (the latest quarter distribution reflects September-November production). The production level was down 41.8% compared to the same production quarter in 2012. The drop in production can be linked to the completion of the drilling obligation (May production quarter/August distribution, as shown in the graph below) to the Trust by the operating general partner, SandRidge. A large number of the wells drilled by the operator for the Trust appear to have resulted in initial high-pressure output, which subsequently declined rapidly, resulting in poor well performance.
In addition to poor well performance, the degradation in earnings performance is also directly linked to the decreasing percentage of liquids (crude, NGL) in Trust production.
Drilling was completed by SandRidge in the spring of 2013. The work was completed at an accelerated pace, well ahead of the schedule set at the IPO.
Based on the date that drilling was completed, the subordination period will end beginning with the August distribution in 2014. Investors need to be aware of this date, particularly since the Trust is not earning enough currently to fully cover the subordination threshold. Based on the current earnings trend, even if natural gas and NGL prices improve, common unitholders will see a substantial drop in distribution level in the August distribution.
Production Mix Analysis
The PV-10 published in the most recent SDT 10-K made a major adjustment in the Trust production mix. As shown in the graph below, the oil & gas mix was split into component oil/NGL/gas parts. During 2013, the percentage of oil expected in the future results was lowered from 23.3% of production to 22.1%. Additionally, the NGL portion of the mix was raised 4.9% to 19.9%, while natural gas was lowered 3.6% to 58.1%. The expected loss of oil production in the PV-10 report had the highest impact on the overall PV-10 value change.
In the graph above, the natural gas and oil percentage mix over the last year is plotted to see if the trend line is actually matching the PV-10 expectation. The trend line is not a positive sign for investors. The result in the previous two quarters was (34% oil/66% gas). The odd part about the reported results is that only 3.8% of total production in the latest September to November 2013 results was NGL, far lower than the published PV-10. This means that it can be expected that oil production will fall very sharply in the near future, displaced by a pickup in NGL production.
Market & Realized Trust Pricing Trends
In the graph below, you can see the actual market prices for oil, gas and NGL during the past year and the last production period. Pricing in the overall market was strong for oil production; however, the price of natural gas was in line with price levels experienced in the fall of last year. The one bit of good news for Trust unitholders is that when the futures price curve for natural gas is reviewed, the current expectations are for a breakout above $4 natural gas through the next several years. Additionally, in the upcoming distribution quarter, which will be based on production volume in the winter months, both NGL and natural gas prices showed sustained high levels, which should be favorable for results.
The weighted average realized price for Trust production during the fall of 2013 was $45.15 per BOE. This is a (0.8%) decrease over the $45.55 per BOE realized in the prior quarter. Year-over-year, the realized price level declined (0.0%).
The minor declines in realized price levels at the Trust can be attributed primarily to lower natural gas prices being off-set by improving realized prices on NGL production, as the differential tightened during the quarter.
Effect of Trust Derivative Contracts
The Trust has oil hedges in place for substantially all of its oil production at $101-$102 through December of 2015. It also carries hedges on approximately 20% of its natural gas volume.
The realized price levels for the latest quarter (oil $95.21, gas $3.38) contain the benefit from the hedges, adjusted for the differentials for delivery of production. The Trust forecasts a differential of approximately $5.00 in the oil price realized and the oil hedge price due to delivery basis risk. The Trust oil production is estimated to be 78% WTI and 28% WTS, and the spread between the two products in the latest quarter was not substantial and should not have affected the realized price above normal expectations. The $95.21 realized price level shows a return to more typical market conditions for product delivery. The improvement in the realized price level for oil production reflects the improving price levels for NGL production.
The natural gas collar contract was supportive to the realized gas price during the latest quarter, although a substantial amount of the production volume is not hedged. If natural gas prices continue to go higher, the realized price level at the Trust will improve. Currently, a $.50 move up in gas prices is giving a 1% move up in realized average BOE price levels.
The Trust has no hedge contracts in place beyond December 2015. Presently, the forward price curve for oil in the 1st production quarter of 2016 shows an average price per barrel of $82.12, and $4.34 per mcf of natural gas. The forward expectations for production sales price levels in the years beyond the current hedged production at the Trust show risk in the oil price curve, and generally high probability natural gas prices will rise above $4 per mcf. (These prices do not reflect the Trust-specific negative differential for underlying product delivery). As hedge expiration gets closer, this risk will need to be continually monitored to adjust expectations.
In the Trust 10-K published in on March 14, 2014, the 2013 year-end PV-10 was supplied, which showed a per share value of $6.23. This value reflects the expected cash flows from the remaining proven reserves held by the Trust, discounted at 10%. The PV-10 calculation uses constant price level assumptions for the life of the proven reserves, as shown in the table below.
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 on-going well performance issues. Since April 2011, 4118 MBOE of the 8992 reduction in MBOE since the Trust IPO, or 45.8%, can be attributed to actual production, while the remaining 54.2% is due to well performance and production mix adjustments. In total, Trust production depletion accounts for 21.7% of the proven reserve decline since IPO, while well performance-related reductions account for a 25.7% 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 $3.10 per MBOE for natural gas production, which was an improvement from the $2.26 used in the calculation in 2012. NGL pricing of $30.69 used in the PV-10 was virtually the same in 2013 as 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, as well as the value of the derivative contracts and the subordination threshold protection for common unitholders, it is necessary to use a discounted cash flow valuation model. The information contained below in this article is based on the valuation model I utilize to evaluate the fair market value of SDT.
The table below summarizes the information used in the model to derive a go forward distribution forecast when combined with the expected depletion of remaining proven reserves held by the Trust.
The product price assumptions in the model use levels derived from the current forward price curve for oil and gas, combined with the Trust hedge contracts in place through the end of 2015. The price forecast for WTI Crude Oil for NYMEX delivery is shown in the graph below. The out year price levels beyond the 1st quarter of 2016 are grown at a rate of 2.5% annually up to a cap level, which in this model are not reached before Trust termination for Natural Gas, and are reached in the last distribution period for oil. NGL prices are assumed to be 50% of the traded price of oil, and the percentage mix of NGL in production is raised to the PV-10 expected level of 19.9%. All prices are adjusted for delivery based on the average differential which is typically realized by the Trust.
The model uses the production mix forecasted in the 12/31/2013 PV-10 of 22.0% oil, 19.9% NGL and 58.1% Natural Gas.
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 unitholder can expect through the end of life of the Trust can be forecast as shown in the graph below.
Through the February 2014 distribution, the Trust showed depletion of 30.4% of its proven reserves. Total remaining proven reserves are estimated at 9,966 MBOE as of the start of the winter production period.
Based on this model, at the current price level of $7.64 on 3/14/2014, the implied rate of return on the Trust, if bought and held to termination, is 9.20%.
If you expect a 10% return, a fair price level for an SDT common unit is $7.34.
Because of the poor track record of the Trust and the elevated tail risk for a continued decline in reserves due to well performance that horizontally drilled wells are systemically exhibiting in the industry, my fair market estimate at this time is $6 per unit, which implies a 15% rate of return, more consistent with the risk profile for this type of investment. In general, my opinion is that buying this asset at any price above the current PV-10 continues to be a "pig in a poke".
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.