Chesapeake Granite Wash Trust (NYSE:CHKR) is an oil and gas trust with royalties for wells in western Oklahoma. As those familiar with my articles know, I analyze trusts using a bottom-up, engineering-style model that considers forecasts of production, sales prices, and expenses and unique underlying circumstances. This article discusses the application of the model to CHKR.
CHKR has underperformed its original targets due to terrible well production and a bad bet on oil prices
CHKR was formed in 2011 by Chesapeake Energy (NYSE:CHK) with a set of initial wells and based on the promise that additional wells, using new technologies, would be added over the ensuing five years. Unfortunately, these technologies and CHKR's production have grossly underperformed expectations.
Production declines will continue and then accelerate when well development ends
As shown in the chart below, quarterly oil, NGL, and gas production (orange, green, and blue lines) have declined since the trust's inception, despite additional well development (grey lines). When development ends, likely mid-2015, production declines will accelerate.
Fig. 1: Historical and forecast production. Source: CHKR SEC filings and author's analysis.
The regression analysis underlying the production forecasts also indicates that the development wells have performed far worse than the original wells. CHK confirmed this suspicion last year, when it announced it would slow the rate of well completions "in an effort to potentially enhance the value of the remaining" wells. While recent production data is too sparse to say if the new approach is working, investors may receive some benefit if the slower pace extends the subordination period.
CHKR's terrible price hedges wipe out oil price upside
At its inception, CHKR received a series of contracts to hedge oil prices around $88/boe through mid-2015. Had oil prices declined, the hedges would have provided the trust with supplemental income. Unfortunately, oil prices rose, leaving the trust on the hook for millions of dollars in settlement costs. These hedges, combined with CHKR's terrible well production, mean that the trust will not capture any of the upside in oil prices until the hedges expire. CHKR is not a good candidate for investors wishing to bet on oil price increases.
CHKR's NGL exposure increases uncertainty in the price forecasts
The chart below shows CHKR's sales prices for oil, NGLs, and gas, as compared to HH and WTI spot prices. Future prices assume that CHKR's prices will follow the NYMEX future market, adjusted for average historical spreads (-$3.98/bbl for oil and -$1.17/mcf for gas).
Fig. 2: Historical and forecast sales prices. Source: CHKR SEC filings, NYMEX oil and gas price futures, and author's analysis.
CHKR's substantial exposure to NGLs is unique as compared to its peers. The model considers NGL forecasts separately from oil and gas, but I have yet to find a market-based price forecast that I like (suggestions welcome). The forecast above uses a weighted average of WTI and HH prices.
CHKR's distributable income will plummet in 2015
Considering production, prices, hedges, and costs together, CHKR's distributable income will decline significantly in late 2015.
Fig. 3: Historical and forecast revenues. Source: CHKR SEC filings and author's analysis
The market appears to have priced in CHKR's troubles
From the model's analysis, we know that CHKR's performance has been terrible and that distributable income is going to decline significantly next year. However, CHKR's terrible results are also old news. As clearly shown in the preceding charts, production numbers have been bad from the beginning and CHKR's price hedges were always clearly spelled out in the trust's SEC filings.
The model's results suggest that CHKR currently offers an NPV-10 of $10.22/share and that, at its current market price ($10.87/share as I write this), represents a yield of 8.7%. CHKR's current yield places it above most of the trusts that I review, suggesting that CHKR could be a possible long candidate.
The view that the market has priced-in CHKR's troubles is further supported by the comparison of price to distribution in the following chart. While the distribution has remained roughly flat due to the buffer provided by subordinated shares, the market price has nearly halved.
Fig. 4: Historical and forecast distribution. Source: CHKR SEC filings and author's analysis.
CHKR's near-term valuation has substantial downside risk, with limited upside
Unfortunately, the chart above also illustrates the major problem with CHKR: the buffer provided by the subordinated shares has been completely wiped out by its terrible production results. Any increases in distributable income will first go to satisfy the subordinated shares. However, further production declines will come at the direct expense of common unit holders.
Investors should further note that, over the long term, the upside and downside price and production risks begin to balance out. Once the price hedges expire and subordinated shares convert, common units will be fully exposed to both production and price swings.
The table below shows the sensitivity of the model's results to various assumptions in prices, production, and discount rate. I typically read this chart in three cases:
- A nominal case that assumes middle case (or best-fit) pricing and production data and a 9% discount rate
- An optimistic case that assumes best-case performance with a 13% discount rate
- A pessimistic case that assumes worst-case performance and a 5% discount rate
These results suggest that even under highly optimistic assumptions, CHKR is worth only $12.38/share, while the downside is $7.16/share.
Fig. 5: CHKR NPV for various price, production, and discount rate assumptions. Source: author's analysis.
CHKR is a possible income play, but investors should be prepared to exit
So where is CHKR heading? CHKR's price hedges and subordinated shares mean that large swings in the market price are not likely to be supported by the distribution, leading to a reversion to the mean.
A possible strategy to take advantage of CHKR's price swings would be to buy on weakness around $10.25 and sell on strength around $11.25. Income investors, however, should recognize that CHKR's distribution and its share price will be declining; CHKR is not a good investment if a steady income stream is needed!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.