The shares of SandRidge Permian Trust (NYSE:PER) traded in a range of $2.50 to $2.75 until the end of September 2016. Then the shares gapped upward breaking the upper bound of the 2016 range. What was the change or news driving the shares? The only news in the market was that SandRidge Energy (NYSE:SD), the Trust operator, was exiting its bankruptcy.
There was no news available on the performance of the Trust until the press release at the end of October, which announced a $0.134 distribution per share compared to $0.12 in the previous quarter. The shares since the late September surge have increased in value by 30% to close at $3.25 on October 28th. The momentum is definitely positive.
Given the surge upward in share price and the visible chart pattern throughout 2016 showing the shares pulling back every time, the price level rises above $3.00, why would an investor buy these shares now? What is the possible catalyst that would make these shares a good play now, even though they may be fully valued on a fundamental basis? This report provides insights into how an oil spike higher in 2017, which most of the "experts" would tell you cannot happen is not priced in the shares at the present time.
Therefore, given that the risk associated with the share distribution while SandRidge Energy was in bankruptcy has been greatly lowered, buying these shares now, holding them while collecting a steady dividend of $0.12 to $0.13 per quarter while you wait for the oil market to tighten and spike higher, is a solid investment strategy.
SandRidge Energy Exits Bankruptcy - Risk Subsides on Permian Shares
On October 4, 2016, SandRidge Energy exited bankruptcy after a pre-packaged deal wiped out the existing common shareholders and restructured $4.1B in debt. The company is now owned by the debt holders, and has $525M in liquidity to try and make the company profitable going forward.
The massive elimination in debt from the re-organization has virtually eliminated the risk of any intermediate term disruption of the Permian shareholder distributions due to the financial risk previously posed by the SandRidge financial condition. The shares of the re-organized SandRidge Energy, as shown in the chart above, are now actively traded and had a recent closing price of $23.79 on October 28th.
Distribution Performance Review
SandRidge Permian declared a common unit distribution of $0.134 in a press release on October 27, 2016. The distribution was slightly higher than the previous quarter when $0.12 per share was paid to unitholders.
In the August distribution quarter, improving oil prices led to a solid uptick in distributions. The current quarter witnessed a continued rebound in the price of oil realized from Trust production, and thus, the $0.014 a share earnings per share increase.
The good news for shareholders is that higher distribution level is expected to be maintained as long as oil trades in the spot market in the $50 range. Currently, my expectation is that the next two distributions will be in the $0.12 to $0.13 per share range. Beyond that point, continued production declines worldwide, which should be expected by investors, will continue to put pressure on the price of oil to spike higher.
At current price levels, oil exploration throughout the world is greatly curtailed compared to prior years, and supply constraints will eventually return to the market, possibly as early as the summer of 2017. An oil spike higher to encourage oil exploration to return to the market worldwide would benefit Permian Trust shareholders through higher distributions, and is not, in my analysis, priced into the shares currently.
SandRidge Permian Trust Earnings Performance Analysis
During the last quarter, production volume was 204 MBOE, less than production in the previous quarter by 4.7% (the November distribution primarily reflects June-August production). The production level was down 21.2% compared to the same production quarter in 2015.
Trust distributable income was $7.03M in the most recent quarter, an increase of 11.4% quarter over quarter. The Trust realized higher prices for its oil production which more than made up for the 4.7% decline in overall production volume.
Oil and Gas Market Pricing Trends
In the graph below, you can see the actual average monthly market prices for oil, gas and NGL during the past year and the last production period. During the latest production period, oil prices held steady in the $45-$50 range, up sharply from the $25 per barrel mid February low. NGL pricing, however, continued to show weakness. Natural gas finally rebounded from very depressed levels.
The weighted average realized price for crude oil at the Trust was $43.13 per barrel in the June to August production quarter.
As seen in the graph below, the Trust was able to realize $37.64 per BOE for its overall production in the last quarter, an increase of 13.1%.
As of the beginning of the end of October 2016, investors can expect an estimated $38 per BOE for the Permian Trust product mix in the distribution scheduled to be paid in February of 2016. Thereafter, realized price levels are expected to hold steady in the $38-$40 per BOE range until a market catalyst changes the current oil market dynamics.
Current Oil Price Forward Expectations
Since the Permian Trust has no oil hedge contracts, and oil production is 81.4% of current production, expected oil prices are a crucial factor in forecasting future PER earnings results. The following graph has been created to help investors visualize the current expectation for crude oil prices through the end of 2021, and how the expectations have changed since August of 2015, a critical time in which oil prices, after already falling from the $100 level since August of 2014, broke down even further to levels much lower than many in the market expected.
Oil prices dropped from the $50 range in August 2015 to lows in February 2016 around $25 per barrel. The forward contracts across the board have now rebounded sharply since the February lows, but still remain below the August 2015 levels. The front month contracts continue to show signs of strength and I expect spot market prices eventually break through the ceiling being created by the August 2015 price levels.
However, the longer dated contracts are not showing the same level of strength, yet. The futures curve continues to place constraints on oil exploration as oil drillers need the longer end of the market to rise in order to hedge their drilling bets. As long as the prices remain capped in the current range, supply will continue to tighten.
This forward curve induced supply tightening is exactly the condition, which is causing the front-end of the futures curve to begin to show signs of spiking higher, and why the recent downturn in prices in August 2016 was not maintained. Based on the movements in the futures curve, I expect the next market move is very likely to be a much more pronounced spike, particularly on the front end of the curve, most likely by the summer of 2017.
The more extended the period of time that the futures curve inhibits long capital spending on oil exploration, the more dramatic the price spike is likely to become.
In the Trust 10-K published in March 2016, the 2015 year-end PV-10 was supplied which showed a per unit value of $3.21. This value reflected, as of 12/31/2015, the expected distributable cash flows from the "estimated" remaining proven reserves held by the Trust, discounted at 10%.
Adjusting for recent production of 639 MBOE during through August of 2016, the PV-10 is estimated to have declined in value to approximately $2.96 per share. At the recent closing unit price of $3.25 on 10/28/2016, the Trust is currently trading at a PV-10 multiple of 1.10 times.
The PV-10 utilized prices that remain very reasonable compared to the current energy market. As the table shows, the oil price in the estimate was $47.35 per barrel. Through the end of life of the Permian Trust, proven reserves are estimated to be 84.9% of production in the PV-10. However, one nagging issue with the Permian production is the growing dilution of the oil production with less valuable NGL and natural gas production. In the past quarter, oil production was only 81.1% of production.
Fair Value Estimation of Permian Units
In order to gauge the fair value of the Permian Trust units against the backdrop of volatile energy prices and other risks, investors should assess the potential distributions they will receive through the end of life of the Trust. This report utilizes a discounted expected distribution model to estimate the present fair market value for each Trust share.
The model utilizes the forward CME price curve for oil and gas products through year-end 2021, and thereafter, grows price levels at 2.5% per annum. The estimated price levels received for oil and gas products are adjusted for delivery based on the average differential, which is typically realized by the Trust.
The model uses a product mix that has been adjusted for the erosion in oil production being experienced by the Trust wells, which is being exhibited by a higher concentration of NGL and natural gas. The model product mix utilized is 81.1% oil, 12.4% NGL and 6.5% gas.
When the expected price and product mix assumptions are combined with the expected production rate of remaining proven reserves held by the Trust, the distributions each quarter a unit holder can expect through the end of life of the Trust ($5.78 in total from August 2016 through 2031 at current expected prices) are forecasted and illustrated in the graph below (see the blue line).
Including the production on which the August 2016 distribution is based, the Trust has depleted 49.6% of its reported proven reserve estimate. Total remaining proven reserves are estimated at 7,494 MBOE.
Based on this model, at the closing price level of $3.25 on 10/25/2016, the implied rate of return on a Trust unit if bought and held to termination is 9.40%. If you expect a 10% return, a fair price level for a PER common unit is $3.10 up to the November 8th ex-dividend date. After the ex-dividend date, the valuation estimate at a 10% DCF estimate falls to $2.98 per unit.
The model distribution valuation is slightly above the PV-10 primarily due to the forward product price expectations in the forecast. In the distribution model, the average realized oil price over the next 5 years is $48.68 per barrel versus $47.35 in the PV-10.
Sensitivity of Trust Unit Price to Oil Price Changes
Does a 9.40% implied rate of return give an investor a fair return if they purchased a Permian Trust unit today at $3.25, particularly given the recent surge in share prices? The risk of the shares suffering a distribution disruption is certainly far lower than previous quarters. But, is the price fair given the trend and expectations in the oil market today?
To help investors assess this question a price sensitivity table has been prepared which shows how the valuation model changes if the implied forward price of oil rises or falls from its current market level. As you can see in the table below, the Trust is valued at $2.76 per share when forward oil prices are assumed to average $50 per barrel over the next 5 years and thereafter increases by 2.5% per annum through the Trust end of life.
If you believe that oil prices are the primary risk facing Permian Trust shareholders, and that $50 per barrel is a longer-range market floor, then the current traded price of the Trust is a favorable investment opportunity. The opposite is true if you think prices will be lower.
Bottom Line - Belief oil prices will spike in 2017 primary rationale to buy at current share price level
Based on the analysis in this report, my opinion is that the Permian Trust has a fundamental fair value of $3.00 given the current 5-year forward oil futures curve, and given the lower Trust risk profile now that SandRidge Energy has exited bankruptcy.
However, this estimate gives little option value to the shares should oil prices spike over the next several years back to $70 and above. The oil market is in the process of tightening substantially, and I believe it will move back toward the $60-$70 per barrel mark by the summer of 2017.
A weakening of the US dollar back to 2014 levels would make this price point in oil a virtual certainty in my opinion. Thereafter, geopolitics will likely determine if it remains in this range for many years as the Saudis have implied in public discourse, or pressure due to conflict in the region ultimately disrupts supply to the extent that the world heads back to $100 oil or even higher.
Absent a continued oil market upswing catalyst as a growing probability in your investment perspective, you might avoid paying up for the SandRidge Permian shares at the current market price. However, should such a spike materialize, SandRidge Permian unit holders will be big beneficiaries in both capital gains in share value and ongoing distributions. Currently, given the oil market seems to have found a floor in the $45-$50 per barrel range, Trust investors are being paid a good return to wait for the market catalyst to occur.
Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor. 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 am/we are long PER. 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.