Due to the overvaluation of Whiting USA Trust II (WHZ) units by Whiting Petroleum's (NYSE:WLL) own recent production estimates, Stratesis has taken a short position in WHZ, expecting a significant drop in unit price to fair value around $9.90.
WHZ is an oil and gas trust that Whiting Petroleum Corporation offered to investors in March 2012 to raise $300 million in exchange for a time or volume limited future right to quarterly production earnings (distributions) from some of its oil and gas wells. Anyone investing in WHZ is cautioned to read Whiting's FAQ due to the trust's unique characteristics. Here are a few important excerpts:
Q - How long are the trust's distributions expected to last?
A - The net profits interest will terminate on the later to occur of (1) December 31, 2021, or (2) the time when 11.79 million barrels of oil equivalent (the oil and gas reserves attributable to the trust) have been produced from the underlying properties and sold.
Q - What will be the value of the units when the trust terminates?
A - Zero. There will be a final cash distribution to unitowners, and the properties associated with the trust will revert back to Whiting Petroleum Corporation.
Q - To determine the yield from the trust's distributions, does one take the total annual distributions and divide by the purchase price?
A - The distributions include return of capital so they should not be treated as dividends. The estimated internal rate of return on the trust based on the initial offering price of $20 per unit is approximately 9.00%.
The trust will terminate at $0 once the committed reserves have been produced, or December 31, 2021, whichever is later, with one following distribution in February 2022 for the Q4 2021 production. This provides a simple way to estimate the value of the trust: future production earnings up to the termination are the total amount of distributions (return of capital) to expect, with no residual value in the units themselves at termination. At termination the wells and their future output revert to Whiting. These quarterly distributions are best viewed as a return of capital with profit or interest.
Whiting did its own estimate of investors' potential returns, declaring above an annual internal rate of return, IRR, of 9% if purchased at the unit offering price and held to termination. Whiting and its WHZ offering underwriters deemed this a fair return for the trust given the long-term risk and volatility of well production and commodity prices.
Using Whiting's own recently updated production estimates and this same expected 9% annual return we will show that current prices ($13) are 11% to 39% overvalued and that current fair value is below $10.
First we will provide a quick and simple relative price comparison to show that WHZ has become overvalued compared to year ago prices. This will be less analytical without providing a lot of detail and references to our sources. We can use this to check our more detailed work below where we calculate remaining distributions and where we provide references and supporting information. This will take some time and effort, but it is the best estimate we can do for these trusts that are not like any company, REIT or other security.
Note that we do not perform a simple calculation of the number of remaining distributions times an average dollar amount per distribution, as many investors often erroneously do with these trusts. The distribution amounts are too volatile, they typically reduce over time, and this method does not take into account the true financial structure of these trusts: a return of capital with a profit payment embedded in each distribution for what is effectively a wasting asset with reduced capital over time.
Quick Historical Price Comparison
WHZ should go down in price by a little less than the amount of each distribution as capital is returned and production earnings are paid out. We say the unit price should go down 'a little less than each distribution' because each distribution can be viewed as a portion of return of capital and a portion of interest or earnings on that capital. It is the return of capital that reduces the future value of the trust, whereas the earnings on the capital are effectively profit taking and do not reduce the future value of the trust.
We'll explain the reasoning behind this next number later below, but the portion of each quarterly distribution that is profit should be about 2.25% of the current trust unit price (i.e., 9% expected annual return divided by 4 distributions per year = 2.25% of profit per distribution). At $13 unit price, that is about $0.29 profit or interest on capital for each distribution ($13 X 0.0225), with the rest of each distribution being return of capital. Note that these numbers need to be adjusted as the unit price changes since the return on marginal (or the next dollar of) capital committed (or retained in the trust) is a function of the current unit price and future distributions.
The trust unit price should not generally recover after each distribution since no capital is recovered or added to the trust. One small exception to this rule is that between distributions the price should rise very gradually into the next distribution since profits of the upcoming distribution are closer in time for the capital committed and therefore the trust units are worth marginally more near the distribution. However, this impact should be much smaller than what we generally see with these trusts including WHZ, likely due to dividend seekers pursing payouts as the distribution date approaches without regard to capital reductions. The only other way that capital can be recovered or added in these trusts is from changes to production estimates and commodity price forecasts which change the remaining value of the trust.
A simple way to compare the current valuation with prior valuations is by looking at the price chart to see if it has gone down in price by the amount of the return of capital for a given period. We will look at the past year. From Yahoo's basic WHZ chart we will focus on April 2013 to today:
In the above chart, prior to April 2013 the trust was falling in price, as expected for a wasting asset. But since April 2013 it has not fallen in price.
Yahoo's interactive chart with distributions shown (click Events and choose 'Dividends') shows the distributions paid since April 2013:
|Distribution Date||Distribution||WHZ Price|
May 16, 2013
|August 15, 2013||$0.739||$13.09|
|November 15, 2013||$0.888||$13.52|
|February 14, 2014||$0.651||$12.92|
|May 16, 2014||$0.671||$13.14|
|Total Distributions For Period||$3.581|
WHZ's price has remained between $13 and $14 for more than a year even though it has paid 5 distributions worth $3.58 total. Of that $3.58, we can consider about $1.45 as profit or interest (5 distributions X $0.29 profit per distribution) and the remaining $2.13 as return of capital. The trust unit price should have gone down by the amount of return of capital, or $2.13, from $13 to about $11. Instead it has remained above $13, or a 15% overvaluation from year ago prices.
Below we show that on March 13, 2014 the trustee announced that production is running about 10% above original estimates through termination, which could add value to WHZ long-term if it continues. Keep in mind WHZ is a variable termination trust based on the later of the minimum production or December 31, 2021, so reaching the minimum production prior to that date actually increases the amount of distributions as they will continue until the end date. While this may justify a 10% increase over the past year, and hence a current $12 vs. $11 fair price compared to a year ago, note that no sustained price spike occurred in March 2014 when this was announced, so investors were either already building the higher production into prices over time or are discounting the ability for the higher production to continue to termination, both of which puts us back at an $11 current fair price compared to a year ago. Unit prices have remained too high over the past year given the amount of capital returned and thereby lost from the current value of the trust.
$11 is a rough current fair value estimate using a comparative method. If prices were fair a year ago, then $11 would be a fair price today. More certainly, when a wasting trust like this remains at the same price level for an extended period as WHZ has for a year now, a future sudden drop in price becomes inevitable. The longer this continues the more drastic the drop will be. See WHZ's sister trust WHX for a recent drastic example.
While $11 is a fair price today based on year ago prices, we believe that in April 2013 the trust was already overvalued by about 10%, making current prices even more overvalued. Below we will calculate the full valuation of the remaining WHZ production and show that current fair value is below $10, 24% or more below current prices of $13.
Deep Dive: Future Production Estimates
To calculate the future production earnings, and therefore the remaining distribution amounts, we will use the same methodology that Whiting uses in its most recent distribution calculation, repeated here from the May 16 distribution:
Natural gas (MCF)
Average sales prices:
Oil (per Bbl)(1)
Natural gas (per Mcf)(2)
Natural gas sales
Total gross proceeds
Lease operating expenses(3)
Cash settlement (gains) losses on commodity derivatives(4)
Percentage allocable to Trust's Net Profits Interest (NPI)
Total cash available for the Trust
Provision for estimated Trust expenses
Montana state income taxes withheld
Net cash proceeds available for distribution
Trust units outstanding
Cash distribution per Trust unit, May 16 ex date
The most recent 10-Q filing page 10, Trust Termination states:
As of March 31, 2014 on a cumulative accrual basis, 3.55 MMBOE (33%) of the Trust's total 10.61 MMBOE have been produced and sold.
So we have 10.61 minimum MMBOE to the trust - 3.55 MMBOE allocated so far = 7.06 MMBOE remaining of the production minimum. If this amount is produced prior to December 31, 2021, then unit holders get 90% of the additional well production earnings until that date. There is an upside potential to WHZ beyond the minimum production if production is faster than estimated at the 2012 offering. Indeed, Whiting has been producing faster than originally estimated, as stated in the above 10-Q:
The remaining minimum reserve quantities are projected to be produced prior to December 31, 2021, based on the Trust's reserve report as of December 31, 2013. Since the Trust is not currently expected to contractually terminate until December 31, 2021, additional reserves and production attributable to the NPI may be available for distribution to unitholders (also based on the year-end reserve report) between the time that the Trust's minimum 10.61 MMBOE have been produced and sold and the expected December 31, 2021 termination date of the Trust occurs. Accordingly, the Trust's remaining reserves attributable to the 90% NPI were estimated to be 8.15 MMBOE as of December 31, 2013, which is more than the minimum and there is no assurance that the Trust will receive more than the minimum amount of reserves. The Trust's Annual Report on Form 10-K includes additional information on the Trust's reserves as of December 31, 2013.
As of December 31, 2013 there remains 8.15 MMBOE estimated production for WHZ unit holders through December 31, 2021 (first announced March 13, 2014, top of page 36). We can calculate what that translates to after the May 16, 2014 distribution by subtracting the latest quarter's production amount: 8.15 MMBOE - 385,308 BOE from the above table (0.3853 MMBOE) produced 1st quarter 2014 = 7.76 MMBOE estimated remaining production to WHZ unit holders. This is 0.7 MMBO3 (7.76 estimated remaining - 7.06 minimum) more than the minimum, or a 10% increase from the remaining minimum (0.7 / 7.06). This is great news for investors. This 10% higher production estimate should justify a commensurate 10% higher price for WHZ. But from what levels? We still need a baseline fair value for WHZ.
In order to calculate the current fair value for WHZ, we will use the following assumptions for the remaining production and oil and gas prices at three different levels:
- Low-End Assumptions: Minimum remaining production of 7.06 MMBOE, $71.28/barrel oil1, $4.26/Mcf gas2 for the trust realized sales prices. See the below notes 1 and 2 for how these were derived. While on the low end, these are plausible numbers going forward based on recent historical production and prices.
- Middle: Whiting's current remaining production estimates of 7.76 MMBOE (10% higher than originally estimated), $79.20/barrel oil1, $5.32/Mcf gas2 realized by the trust. These are the most likely estimates using industry forecasts. Again, see the below notes for how these were derived.
- High-End: 5% additional increase in remaining production to 8.15 MMBOE, $87.12/barrel oil1, $6.38/Mcf gas2. These require sustained production increases and relatively high levels of sustained commodity prices for 7.5 years, which we believe is less likely than the above scenarios. But we want to leave the upside open to demonstrate the current overvaluation.
1The above oil price assumptions range from 10% below, at, and 10% above the 2014 to 2021 average nominal IMF crude price forecasts of $94/barrel minus $4 for the Brent/WTI spread, for a $90 mid-point. The Brent premium over WTI crude is currently greater than $4 ($7), but we are starting with the IMF average of Brent and WTI, hence the reduction to a $4 difference. Over the next 3-5 years, the Brent/WTI spread may decrease if transportation constraints to WTI are removed (e.g., more US pipeline capacity and the ability to export crude oil from the US).
The above oil prices are also adjusted down to the particular mix of WHZ natural gas liquids included in its oil output, which tends to reduce WHZ's oil sales price below spot WTI crude prices by about 12%, for a $79.2 mid-point (0.88 X $90), $71.28 low-end 10% ($79.20 X 0.9) and $87.12 high end 10% ($79.20 X 1.1).
See the prior 8-K's sub-note 1 for the May 16, 2014 distribution, repeated here for the explanation of these 'low' realized oil prices:
Oil (PerBbl)(1) $86.77
(1) Oil includes natural gas liquids.
WTI crude averaged $98 during this quarter, yet WHZ only realized $86.77 in oil sales price due to the natural gas liquids content. This effectively reduces the realized price from WTI prices by about 12%. This is a function of the wells and has been true for recent distributions.
2The above natural gas price range is 20% below, at, and 20% above the long-term IMF US domestic market natural gas price forecasts of $4.51/Mcf (the average IMF price listed $4.40/mmbtu multiplied by 1.025 to convert from $/MMBtu to $/Mcf). This provides a range of $3.61/Mcf (0.8 X $4.51), $4.51 Mcf and $5.41 Mcf (1.2 X $4.51).
These are then adjusted up 18% due to the liquids rich content of WHZ natural gas which demands higher prices (see prior 8-K's sub-note 2) to obtain the range of $4.26/Mcf ($3.61 X 1.18), $5.32/Mcf ($4.51 X 1.18) and $6.38Mcf ($5.41 X 1.18). We use a larger range spread (20% each) for natural gas prices vs. oil due to the higher volatility and greater uncertainties around US natural gas prices long-term.
While these crude oil and natural gas price forecasts may seem low compared to current prices, keep in mind that current prices are higher than recent and long-term historical prices. Hence the lower long-term IMF price forecasts. While oil and gas prices can spike or dip short term, in the long run they typically revert to the cost of production plus a small margin as producers increase or lower their output based on profitability. Also note that these long-term crude oil and natural gas forecasts more than 5 years out are subject to many moving variables. They will change.
We use the same percentages of oil to natural gas (77%/23%) and cost percentages of revenue as the last few distributions. In reality, as stated in Whiting's recent 8-K's, costs will likely increase as a percentage of production and sales due to fixed and semi-variable costs while production slows 8.4% annually:
Additionally, the year-end reserve report reflects an expected annualized decline rate of approximately 8.4% between 2014 and 2021. However, cash distributions to unitholders may decline at a faster rate than the rate of production due to fixed and semi-variable costs attributable to the underlying properties, or if expected future development is delayed, reduced or cancelled.
This means our below current percentage cost calculations are likely too generous (i.e., costs are too low, thereby resulting in higher profits), which we allow in order to clearly demonstrate that WHZ is currently overvalued.
For our final assumption we will assume that the risk free rate is the same now as it was in March 2012 and that an appropriate discount rate for WHZ has not changed significantly since then either, but we will add a reality check to those assumptions. We believe that making this discount rate assumption is easier said than done given the Fed's long artificial strangle on the 3 month treasury bill rate which is one proxy for the risk free rate, and the market's groping for higher rates of return sometimes regardless of risk, which confuses appropriate risk premiums and therefore discount rates. In March 2012 the 3-month treasury bill rate was 0.05%-0.1%. Today it is 0.04%. Both are effectively zero, hence our assumption of no change to the risk free rate when we're talking below about a 9% expected internal rate of return for WHZ.
For the discount rate one could argue that it should be lower now than in 2012 given the high market returns since then and expectation that current market returns (the risk premium) will be lower. In hindsight that may be true, but in 2012 no one knew that 2013 market returns would be so high. Rather than argue what a 'correct' risk premium and discount rate should be, we will first assume it has not changed, and then we will change it wildly to show WHZ is still overvalued. Finally we will show what the discount rate would have to be to justify current WHZ prices. We don't like spoilers, but market theory basically breaks down if we accept a discount rate low enough to justify current WHZ prices.
Future and Current Fair Value Based On Remaining Distributions
Here is the WHZ future and current value calculations using the above 3 ranges and assumptions:
|Sales volumes:||Low-End||Middle Best Estimate||High-End|
|Natural gas (Mcf, 6 Mcf = 1 BOE)||9,681,156||10,647,479||11,179,852|
|Average sales prices:|
|Oil (per Bbl)||$71.28||$79.20||$87.12|
|Natural gas (per Mcf)||$4.26||$5.32||$6.38|
|Natural gas sales||$41,203,002||$56,644,586||$71,372,178|
|Total gross proceeds||$429,427,663||$531,061,476||$619,323,686|
|Lease operating expenses (38%)||$161,890,870||$200,206,023||$233,480,186|
|Production taxes (5%)||$22,597,195||$27,945,335||$32,589,838|
|Development costs (9%)||$38,041,829||$47,045,292||$54,864,201|
|Realized (gains) losses on hedging settlements||Assume remains zero as they are extreme cases||Hedging contracts end 12/31/2014|
|Percentage allocable to Trust's Net Profits Interest||100%, We're using total NPI remaining vs. 90% of total production||100%||100%|
|Total cash available for the Trust||$206,897,769||$255,864,826||$298,389,461|
|Provision for estimated Trust expenses (1.985%)||$(4,106,685)||$(5,078,625)||$(5,922,691)|
|Montana state income taxes withheld (.025%)||$(51,859)||$(64,133)||$(74,792)|
|Net cash proceeds available for distribution||$202,739,224||$250,722,068||$292,391,978|
|Trust units outstanding||18,400,000||18,400,000||18,400,000|
|Remaining Cash distribution per Trust unit, Future Value||$11.02||$13.63||$15.89|
|NPV, Current Fair Value To Achieve 9% Annual Return on Capital||$7.991||$9.891||$11.541|
1 See below chart for NPV calculations.
The low-end future value of $11.02 is a -15% return from the current price level of $13. Meaning an investor could wait 7.5 years to get a net -15% return on their original investment. WHZ is not risk free.
The middle best estimate again uses Whiting's own production estimates updated December 31, 2013 and forecasted long-term commodity prices. At a $13.63 future value (from $13 price today) that would be a 5% simple total return (not annual) over 7.5 years. 10 year treasuries, even at their low current yields of 2.5%, would be a safer, better long-term investment with little to no downside as long as you plan to hold until the end.
The WHZ high-end future value may look attractive at a $2.89 premium to current prices (+22%), but over 7.5 years to termination that is a paltry annual return.
Whiting and its underwriters built a 9% annual internal rate of return into the initial offering price (see Overview above) given the volatility and risk of production output and commodity prices. We estimate the current fair values (last row in the table above) using a net present value NPV calculation based on this 9% expected internal rate of return and the following series of future payments (returns of capital and interest/profits) using the above total future value of distributions and the above referenced expected annualized production decline rate of 8.4%.
For simplicity and brevity we annualize distributions (vs. quarterly) to fit (average) the annual 8.4% production declines. There are 7 full years (2015-2021) plus 3 additional quarterly distributions remaining. The 3 additional quarterly distributions consist of 2 more in 2014 plus one final distribution February 2022 based on the production through December 31, 2021. So we list 7 full year distributions plus one 3/4 year distribution in the NPV calculation. The objective is to pick the Year 1 distribution that with 8.4% annual reductions and 9% IRR over 7.75 years results in the total distributions or future value from the above table:
|Low-End NPV||Middle Best Estimate NPV||High-End NPV|
|Internal Rate of Return||9%||9%||9%|
|Year 1 distribution||$1.88||$2.32||$2.71|
|Year 2, 8.4% decline||$1.72||$2.13||$2.48|
|Year 3, 8.4% decline||$1.58||$1.95||$2.27|
|Year 4, 8.4% decline||$1.44||$1.78||$2.08|
|Year 5, 8.4% decline||$1.32||$1.63||$1.91|
|Year 6, 8.4% decline||$1.21||$1.50||$1.75|
|Year 7, 8.4% decline||$1.11||$1.37||$1.60|
|3/4 of 1 year, 8.4% decline||$0.76||$0.94||$1.10|
|Total Distributions (Try to match Future Value Above Table)||$11.03||$13.62||$15.91|
|NPV Current Fair Value||$7.99||$9.86||$11.52|
Anyone can input these numbers into MS Excel's NPV function or a similar NPV calculator to get the same current fair values.
In order to get a 9% annual internal rate of return going forward, an appropriate expectation given the volatility and risk associated with WHZ, an investor should only buy units at a current price at or below $8 (low-end), $10 (middle best estimate) or $11.50 (high-end) based on the above ranges. That is a discount to current prices of 11% to 39%, with a best estimate of 24% overvaluation. Investors should be selling at the current price levels and only buying back in below $10.
If we lower the internal rate of return above to 8% given the potential for a lower discount rate now compared to 2012, we get NPV current fair values of $8.26, $10.19 and $11.90, or an 8%-36% discount to current prices. 6% gives us $8.84 low, $10.90 expected, $12.74 high current value, a 2%-32% overvaluation. Still greatly overvalued.
If we raise the internal rate of return above 9%, we get more and more overvaluation in current prices.
We have to reduce the internal rate of return to 1% to get a NPV current fair price range of $11.03, $13.09 and $15.30 to justify current price levels. Investors are pursuing a 1% rate of return on their capital in WHZ. Short term treasury bills or the risk free rate would have to be hugely negative to justify this type of risk in volatile WHZ for 1% return. Market theory starts to break down at those levels. That may be an interesting discussion for another article on treasuries and the current investment environment. Until then, even in light of a market where investors grope for returns, we believe WHZ investors have significantly overvalued this trust and risk significant losses.
Unlike many other similarly overvalued (or disagreed value) trusts and stocks, WHZ has a surprisingly low borrow rebate rate of less than 1%. Regular retail brokers will likely be able to support a short position in WHZ. Puts are relatively inexpensive despite the volatility and potential overvaluation of the trust. Finally, short interest at 80k shares is only about half a day of volume and less than 0.5% of shares outstanding. It is not difficult to short WHZ and hold it short, which is positive if you believe it is overvalued and will fall, but also warrants caution as others don't seem to agree with a short position right now. Shorts are a small group.
WHZ is relatively volatile and may become more volatile as it gets closer to its end date (see WHX). It should get less volatile as termination nears because there is less variability in remaining production and commodity prices, but this has not been the case with similar trusts (see WHX). It also follows a distribution cycle like many other trusts and high dividend payers, rising into the distribution and then falling abruptly at or just after the distribution more than the distribution itself.
Since its offering investors have generally overvalued this trust compared to where Whiting and its underwriters originally valued it at $20. Investors may be willing to accept lower profits given the risk. While there may be many reasons for this, the outcome, if it distributes as much as predicted over its full life, will be that on average long-term investors will experience less than a 9% internal rate of return on the trust. The net effect is that investors are willing to take more risk for less return than generally accepted in the market.
Our above assumptions for current value based on future value may prove wrong in the near to medium term in that investors are too aggressive in pursuing 'dividends' while taking higher relative losses on capital (which is defined by remaining production). As other trusts have shown, this can continue for some time. The longer this continues the more drastic the future sudden drop will be in unit price.
For long positions WHZ has a relatively protected current value bottom of $7.99 (that's current price, distributions will take the absolute price to $0 ratcheted at each ex-distribution date). This protected bottom is due to WHZ's minimum production allocation and 77/23 oil/gas mix with US oil prices being more stable than US gas prices. Of course $7.99 would be a 39% loss from current levels, not exactly a risk-free trade!
Short position risk exists in a potential long-term disruptive increase in oil prices and to a less extent gas price increases due to the 77/23 mix. Increased US oil and gas production have tempered that risk, but the Russia/Ukraine and similar situations could change commodity prices globally over the next 7 years. For those who want to bet on those types of commodity disruptions there are far more pure oil and gas securities vs. this already overvalued trust.
We generally view future changes in well production as an equal risk to short and long positions. Production could go either way, although Whiting has little incentive to try and increase production and give away more output to WHZ, which Whiting would keep for itself beyond 2021. Attempts to increase well output (at potentially higher costs) or to lower output are generally tied to commodity prices and incremental production profitability. This can amplify positive and negative impacts to end-date-based trusts like WHZ in that higher commodity prices favor higher production rates (if possible) whereas lower commodity prices favor lower production rates.
We believe that the overall risk profile strongly favors shorts over longs given the current 11% to 39% overvaluation and the ability to enter and hold a short position medium to long term due to low borrow costs and low put premiums.
Disclosure: I am short WHZ. 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.
Additional disclosure: We may enter or exit positions in WHZ over the next 72 hours. Forward-Looking Statements: This article contains "forward-looking statements." Generally, the words "anticipate," "believe," "estimate," "expect," "will," "would," "could," "intend," "may," "predict," "project," "plan," and similar expressions identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements to differ materially from any future results, performance, or achievements expressed or implied by such forward-looking statements. Consequently, no reliance should be placed on any forward-looking statements contained herein and the reader should consider any such forward-looking statements only as Stratesis's current beliefs as of the date of this press release. Even if these beliefs change because of future events or circumstances, Stratesis declines any obligation to publicly update or revise any such forward-looking statements.