As investors are painfully aware, the last two months have been tough on the oil and gas sector. A steep decline in commodity prices triggered a broad sell-off of oil and gas trusts that was further exaggerated by year-end tax-loss selling and investor fears. For contrarian investors, however, the big sell-off may have created opportunities for value investments.
This article presents a comparison of 13 oil and gas trusts given the big changes in commodity and market prices.
Every oil and gas trust is unique
As those familiar with my articles know, I forecast the future distributions of oil and gas trusts using an engineering-style, discounted cash flow model. The model's forecasts depend on unique trust-specific information (taken from SEC filings), so each trust is forecast separately and has its own unique assumptions. In general:
- Production is forecast based upon a best fit power function applied to historical well depletion rates and expected future well completions and work overs; published reserves are excluded
- Sales prices are forecast as NYMEX Henry Hub and WTI futures, adjusted for historical spreads
- Costs are forecast individually based on prior costs, revenues, production, and inflation
- Termination dates, terminal value, share subordination, and unique passive income streams are considered
From the model's results, I calculate summary statistics, including forecast internal rate of return, or IRR, and net present value, or NPV. Two statistics that I use to guide my own selection of trusts are Fair Value, or FV, which is the NPV at a trust-specific discount rate, and the ratio of market price to FV. In general, I consider trusts with ratios of less than 1.0 to be candidates for long positions.
In addition to the model results, I also develop a separate estimate of each trust's value based upon the most recently available reserve report. While these reserve reports often exclude key financial figures, such as the hefty overhead fees paid by Hugoton Royalty Trust (NYSE:HGT), they may portend how Mr. Market will treat a trust.
Of the 13 trusts that I reviewed using the model this quarter, the expected IRR at today's prices varies between 21.3% and -0.8%. That's a tremendous range. Some trusts, such as ECA Marcellus Trust I (NYSE:ECT) and SandRidge Permian Trust (NYSE:PER) score highly and could offer significant value if oil and gas prices increase. Other trusts, such as Enduro Royalty Trust (NYSE:NDRO), appear overvalued and could be vulnerable to outsized declines should oil prices fall further.
The table below provides a set of summary statistics for the reviewed trusts, which are ranked by IRR, as of 9 December, 2014. In addition to ECT and PER, Chesapeake Granite Wash Trust (NYSE:CHKR), VOC Energy Trust (NYSE:VOC), and Pacific Coast Oil Trust (NYSE:ROYT) all offer very attractive FV ratios.
Fig 1. Trusts ranked by IRR as of 12/9/14. Source: Yahoo! Finance, Trusts' SEC filings, and author's analysis.
As compared to the prior quarter, the range of trust IRRs has shifted upward, from (+11.3%, -2.0%) following Q2 to (+21.3%, -0.8%) as of 12/9. On the surface, this could be a positive sign for investors, suggesting that tax-loss selling may be creating potential value in the sector, a topic that I explored in an earlier article. However, the shift could also represent underlying pessimism in the oil and gas sector or result from the lesser liquidity of oil price futures, both of which would be bearish indicators.
Volatility in the market is also something for investors to consider. A draft of this analysis last week had VOC far and above all trusts, while CHKR and Whiting USA Trust II (WHZ) were at the bottom. Thus, the analysis presents the prices that I feel are reasonable for the trusts given the prices at market close on 12/9, considering oil at or around $62, and before the next round of quarterly distributions.
The change in valuations also demonstrates the risks inherent in trusts. Investors should always exercise due diligence and examine candidate positions for sources of risk, including those that I discuss in an earlier article on risk methodology, before taking a position, long or short.
Predominantly Gas Trusts
Three trusts derive their income primarily from natural gas:
- ECT has been hurt by declining production, widening price spreads, and whispers over poor performance in the Marcellus. However, ECT's production is entirely gas, and a closer look at the production numbers shows that declines are slowing. The widening spreads in the most recent quarter were a surprise; if they recover, the model forecasts a 21.3% IRR.
- New Mexico's San Juan Basin Royalty Trust (NYSE:SJT), operated by a subsidiary of ConocoPhillips (NYSE:COP), is a rock of gas trusts. Total production is remarkably steady, but that stability comes at a cost to investors. SJT trades at a 3.4x premium to the NPV-10 as based on the reserve report and the model forecasts a mediocre near-term yield of 6.4%. The forecast IRR is 5.5%.
- HGT is a perpetual trust with wells in Kansas, Oklahoma, and Wyoming. The trust is subject to an ongoing litigation, which may offer legal upside. However, the model's forecast, which considers HGT's production declines and the excessive fees that are baked into the trust agreement, suggest that the market is overvaluing future distributions.
Perpetual Oil Trusts
Three trusts have income primarily from oil production and have no fixed termination date (so-called "perpetual" trusts):
- California-based ROYT has steady production and sizeable reserves, and won big at the polls in November when it avoided a potential permitting ban. The model forecasts a 12.2% long-term yield given current oil price futures and the trust also trades at a discount to its price-adjusted reserve report NPV-10.
- Permian Basin Royalty Trust (NYSE:PBT) is a stable oil trust operated by a COP subsidiary. At current prices, the numbers don't amaze, but aren't terrible. The model forecasts a mediocre 4.7% IRR.
- NDRO has wells in Texas, Louisiana, and New Mexico operated by Enduro Resource Partners. NDRO's recent capital program finally kicked in, just in time for oil prices to drop. I expect CapEx to decline and production to drop q/q. However, for those that prefer reserve report valuation, NDRO's market price is basically par with the adjusted NPV-10. though I expect a downward revision come March.
Terminal Oil Trusts
- PER, a SD trust with wells in west Texas, scores at the top. Current prices appear to ignore protections offered by subordinated shares and a final tranche of oil hedges. The model forecasts $2.50+ in distributions over the next 5 quarters alone.
- For CHKR, the drop in oil prices has simply made some of its horrendously-priced oil hedges more palatable. A big price drop in the past week has raised the IRR to 13.7%.
- VOC's distribution was punished last quarter by CapEx costs and future distributions are likely to decline further due to the drop in oil prices. However, market selling appears to be overdone. VOC trades at a discount to its price-adjusted reserve report valuation and the model forecasts a 13.2% IRR and 0.73x FV multiple at today's prices.
- WHZ's market price has tumbled in the past week and the trust now ranks in the middle of the pack. WHZ's performance history is enough to make a decent production forecast, but I'm not yet confident in the model's expense forecasts.
- SDT is an SD trust with wells in the Mississippian formation in Oklahoma and Kansas. Attractive oil hedges are offering substantial upside to investors at current oil prices.
- SandRidge Mississippian Trust II (NYSE:SDR) is SDT's sister trust. Same proprietor. Same formation. Same terrible performance. Less-lucrative hedges. Model forecast suggest that SDR's future distributions will be less than the 12/9 market price.
- MV Oil Trust (NYSE:MVO) has wells in Kansas and Colorado. MVO's market price might be appropriate for a perpetual trust; however this trust will terminate without a residual in 2026. Speculative play only.
Disclosure: The author is long ECT, PER, ROYT, VOC.
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.
Additional disclosure: It goes without saying that both market prices and trust values could change significantly if the prices of oil and gas continue their downward slide or rebound (prices are already down significantly today, 12/10).
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.