The latest reported quarterly results by SandRidge Mississippian II Trust (NYSE:SDR) showed another quarter of sharply lower performance. On July 31st SDR announced its quarterly distribution for production during the time period of February through May 2014. During the spring the energy market showed relatively high oil prices and declining NGL and natural gas prices, the combination of which help to exacerbate a very poor production quarter for the Trust. To make matters worse for the Trust, it recorded a derivative contract loss for the first time even though the contract was at $99 per barrel. As the March through May average pricing for NYMEX WTI averaged above $100 per barrel, the Trust suffered a $418K loss on approximately 225 MBOE in contracts. The absurdity of the situation is that the Trust only produced 121 MBLs of oil and 33.7 MBOE of NGL for delivery against the swap contracts.
The distribution announcement was greeted with a gap down in unit traded price from $8.23 to below $8.00 per unit after the press release. The market price per unit has since stabilized at around $8.00 per unit. The question prospective investors need to ask is "does the current value properly reflects the risk embedded in this Trust?"
Distributions Take a Steep Dive the Past 2 Quarters
The latest reported quarterly results by the SandRidge Mississippian Trust II Trust showed a deterioration of production volume relative to expectations and earnings which provided a below threshold level distribution only to common unit holders. The distribution was the second consecutive quarter in which the Trust failed to cover the threshold distribution level to unit holders. Readers of my previous reports were warned that this trend was likely in my article published on 3/19/2014, SandRidge Mississippian Trust II: PV-10 Reflects another Mississippian Nightmare in the Making. On July 31st SDR announced its quarterly distribution for production during the time period of February through May 2014. During the spring the energy market showed relatively high oil prices throughout, and declining natural gas and NGL price levels after the harsh Midwest and east coast winter. NGL prices declined sharply in the quarter and the spread relative to the price of crude oil widened over the quarter beyond the typical 2:1 range.
In the context of a generally healthy energy market, SDR's common unit distribution of $0.49 was 34.3% below target. During the most recent quarter subordinated unit holders did not receive a distribution.
As the above graph shows, SDR's distribution levels have been declining rapidly over the past 3 quarters. Being unable to bring as many wells into production in the last two quarters, (after accelerated early life drilling by SandRidge) combined with the poor well performance of wells previously drilled has caused the production volume at the Trust to tail off much faster than expected.
The Trust 7/31/2014 press release references lower oil production as the cause for the miss. This statement is made relative to the Trust IPO prospectus which projected a higher overall MBOE volume in crude oil than has been discovered. The change in the Trust product mix has been revised substantially since the April 2012 IPO, with oil now expected to be 25.5% of reserve production going forward, down from 28.2% at the end of 2012. Given the latest production figures this estimate is questionably high.
Given my previous reports that have tracked SDR's performance, the below IPO threshold distribution level that is currently being experienced is not a big surprise, but it is worse than expected. The remainder of the report will focus on providing more detail for the causes of the decline and attempt to put a fair value on Trust given the continued elevated risk and production volatility.
SDR Earnings Performance Analysis
During the last quarter, production volume was 392 MBOE, lower by 7.5% than production in the December-February production quarter (the August distribution reflects March-May production). The production level was down a substantial 40% compared to the same production quarter in 2013. The drop in production can be linked to a lower number of wells being brought into production in the quarter. In addition, the rapid decline in production level quarter over quarter indicates that a high number of wells brought on line had high initial pressure but rapid fall off. Because of this performance issue, the long-tail life estimates of these wells are questionable.
The degradation in earnings performance during the 4th quarter is most directly linked to the combined effect of lower liquid (crude, NGL) production as well as lower realized price levels.
Drilling Progress - Completion Approaching
Drilling continued to slow in the AMI by SandRidge (NYSE:SD) in the previous quarter. Only 6 wells were drilled last quarter, leaving 9 wells remaining to be drilled per the IPO contract between SandRidge and the Trust.
Based on the current drilling trend, completion of the obligation to the Trust to bring on-line 206 wells is expected in the summer of 2014. Completion by August of 2014 means the subordination period will end beginning with the November distribution in 2015 (this is one distribution quarter later than my last report).
Production Mix Analysis
The PV-10 published in the most recent SDR 10-K made another "non-friendly" adjustment in the trust production mix, following a substantial change at the end of 2012. As shown in the graph below, the oil / NGL / gas mix was shifted from 28.2 / 14.7/ 57.1 to 25.5 /19.9 / 55.7. The biggest impact from the adjustment was the continued reduction in oil production expected.
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 reflecting a shift to natural gas and NGL. The trend line reflects the expected lower oil and higher gas output from production. In the most recent quarter, less valuable natural gas production was above 60%, much higher than the PV-10 estimate. The shift to NGL estimated in the PV-10 report is not being fully realized yet, as only 8.6% of total production was NGL in the last quarter. Overtime as production shifts to NGL, a rapid decline in distributable income can be expected.
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, and the level was above the $99 swap price in place at the Trust to hedge oil price fluctuation. The higher market WTI crude oil price resulted in a ($424K) derivative settlement loss during the distribution period. The price of natural gas and NGL, on the other hand, declined sharply during the period after aggressive run-ups during the winter months. The good news is that natural gas and NGL seem to have bottomed at levels higher than the previous 2 years, even with the reports of large supply increases hitting the market from the U.S. "energy boom". The likely cause of this phenomenon is less drilling in the natural gas patch in response to the excessive supply that caused price levels to become uneconomically low in 2012.
The weighted average realized price at the Trust, including the impact from derivatives, was $50.13 per BOE in the February to May production quarter. This is a (5.3%) decrease from the $52.94 per BOE realized in the prior quarter. The bigger impact on realized price levels can be seen in the decline in price per BOE equivalent relative to the same production period in 2013 (10.0%).
The shift in mix to less valuable gas and NGL production volume is the primary contributor to the substantial decline in realized price levels during 2013. The trend to lower oil mix is expected to continue, and is confirmed by the in quarter restructuring of its derivative agreements.
Derivative Contracts Amended in the Quarter Reflecting Lower Oil Output
In April of 2014, the Trust made a material change to the derivative contracts that it currently is a party.
Based on the amended contracts, the Trust now has a new $90.39 per barrel hedge in place for an "estimated" 47% of its liquid production (oil and NGL) through 2015. The Trust does not have any derivative contracts to hedge natural gas prices.
The realized oil price levels for the latest quarter of $83.02 contains the settlement loss from the previous oil hedge, adjusted for the differential for delivery of production. The impact from the contract losses was greater than expected on the realized price because it appears that not only did the Trust suffer from NYMEX prices being above the hedge, but also the fact that the Trust did not have enough oil production to deliver against the hedge - in other words the Trust was overexposed. The amendment undertaken appears to have taken away the excess exposure relative to the production ability of the Trust. However, the implied cost of the contract restructure may be high in 2015 if oil price levels average above $90.30 per barrel, which is presently the expected case in the market. Presently the NYMEX forward price curve for oil in the 1st production quarter of 2015 shows an average price per barrel of $95.36. My initial reaction to the hedge restructure was that the counterparties to the contracts got the better end of this deal.
On March 14, 2014 the Trust published it 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 2012 is 2,522 MBOE, a loss of 9.5% of the estimated reserve level at the Trust IPO. The primary risk that my analysis points to is that this reserve calculation is inflated, and there is a high likelihood that the reserves will be downwardly adjusted to a level that is between 20% -25% of the IPO value by the end of 2014. This estimate is based on the trend in production levels that correlate heavily with the performance at SDR's sister Trust (NYSE:SDT), which is one year older than SDR.
For reference, after the first 21 months of operation (end of 2012), SDT showed a net reduction of IPO estimated reserves of 9.7%; 12 months later (end of 2013) SDT showed an impairment of reserves due to well performance of over 25%. By comparison, SDR as of the end of 2013 showed a negative 9.5% reserve reduction after 21 months of operation, leaving open the high probability that reserves with be revised aggressively downward at the end of 2014.
In the Trust 10-K published in early March 2014, the 2013 year end PV-10 was supplied which showed a per share value of $7.31. This value reflected, as of 12/31/2013, the expected cash flows from the estimated remaining proven reserves held by the Trust, discounted at 10%.
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 46% / 54%. Through time the PV-10 report has been adjusted to reflect the reality that the Trust will deliver less oil than expected, instead delivering a higher concentration of far less valuable natural gas and NGL. Additionally, the initial reserve report (April 2012) did not indicate NGL in the production, thus making the 2012 PV-10 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 25/19/56, oil / NGL / Natural Gas.
In the table below you can see the market price assumptions used to derive the PV-10 estimate. The price levels for oil and NGL production, which comprise 44% of Trust estimated reserves, are in-line with current market price levels. The natural gas price used in the estimate is below the current market.
The remainder of this report will focus on whether the current traded unit value, which is relatively close in value to the most recent PV-10, is a fair value given the derivative contract amendment and the risk of future proven reserve write-downs.
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 or proven reserves 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 SDR.
The assumptions contained in the following table allow the creation of a go forward distribution forecast when combined with the expected depletion of downwardly estimated 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 oil hedge contracts in place thru 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 2015 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 year of 2030 for oil. NGL prices are assumed to be 50% of the Trust realized price of oil, and the percentage mix of NGL in production is raised to the PV-10 expected level of 18.9%. All prices are adjusted for delivery and post production cost based on the average expense which is typically paid by the Trust.
The model uses the production mix forecasted in the 12/31/2013 PV-10 of 25.5% oil, 18.9% NGL and 55.6% Natural Gas.
When the price and mix assumptions are combined with and updated downward estimate of 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.
The production curve in the model has been revised downward by 12% of proven reserves relative to the initial IPO estimate to model the current well performance levels being exhibited by the Trust. This estimate is in-line with the SDT historical proven reserve revisions and production performance. With this revision the Trust is estimated to have 15,890 MBOE in proven reserves remaining as of the beginning of the latest production quarter, not 19,088 as would be estimated using the latest PV-10. Based on the model assumptions, the estimated value of distributions which will be made by the Trust is $14.59 through Trust termination in 2031.
Based on this model, at the current price level of $8.03 on 8/11/2014 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 SDR common unit is $7.75 prior to the ex-dividend date of August 12, 2014. The valuation estimate should be adjusted downward approximately by the distribution amount of $0.48 post ex-dividend declaration.
Based on this analysis, my fair market is $6.50 per unit post the ex-dividend date. The primary reason for the continued lower than market valuation estimate is that the Trust continues to exhibit unstable well performance results which demand a higher market risk premium applied to expected future pay-outs. Currently it appears that the market is relying heavily on the most recent PV-10 for pricing support; however, in all likelihood 12/31/13 PV-10 is overstated based on the actual production levels being reported by the Trust.
Daniel Moore is the author of the book Theory of Financial Relativity. 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: The author is long SDR. 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.