For this analysis, we are going to assume that investors can hedge oil and natural gas prices using the futures markets. Otherwise, commodity prices would certainly be the most significant variable. However, if hedged, the value rests instead on the future decline rate.
The Sandridge Permian Trust (NYSE:PER) produces entirely from the Furhman-Mascho field in Andrews County, TX. The field consists of several scattered reservoirs, all of which are located within the San Andres and Grayburg formations (i.e. rock layers). Despite the "Permian" moniker, the Furhman-Mascho field is not located within either of the two main Permian sub-basins (the Delaware Basin and the Midland Basin) but is rather in the "Central Basin Platform" between the two basins.
The field was discovered in the 1930s, but production didn't ramp up until the 1950s and 1960s, at which point, it was developed using 40-acre spacing.
In the early 2000s, geological arguments were made that suggested there could be more oil and gas in place than initially estimated. This led to increased estimates of what could be recovered, and since the actual results were less than these estimates, this led some to speculate that the average drainage area for the older wells drilled in the 1950s and 1960s had been much smaller than the 40 acres previously assumed.
This led several companies to return to the area in hopes of finding success with "infill drilling" programs. Range Resources took the lead, experiencing some success from 2003 to 2005, but quickly sold its stake to Energen. The second player was Arena Resources. Arena pursued the infill drilling concept with zeal, passing its momentum on to Sandridge when Sandridge acquired Arena in mid-2010. Sandridge then spun off a chunk of the field as the Permian Trust in 2011. Sandridge sold the rest of its producing acreage to Sheridan in late 2012. The graph below tells this story visually, showing production by operator during this time period.
There's a lot we can take away from this one graph. First, we can see that the runup in production was driven by the Arena/Sandridge combo. Without that, there wouldn't have been much of a peak. While Range gets credit for being the first to enter, its impact was relatively small.
The second thing to notice is the steepness of the current decline rate. Since the beginning of 2014, the decline rate has not flattened out from its alarming 20% annual decline rate.
If we make the extremely conservative (and unrealistic) assumption that this decline rate will continue without flattening, the trust is worth just 66% of its current market cap. If, on the other hand, we make a more realistic assumption that the decline rate will flatten out to 9% in 5 years and 6% in 10 years, we get a valuation of $140 million - just slightly below the current market cap of $157 million.
To get a value that matches the current market cap, we need to assume the curve will flatten out rather quickly and hit 9% in under 4 years. While this is a mild stretch and not too crazy an assumption, it would seem odd to hold out such hope for the mere possibility that the trust might be worth its current market cap. Only in the most extreme and unlikely situations is the Trust worth more than its current market cap.
With so little room for improvement (and such little upside if that happens), one would think this must be a very low-risk investment. How else could it fetch such a valuation? Yet, as we shall see, the risks are many.
The figure below shows the original development plan for the Trust's "development wells" taken straight from the S-1 filing. The plan involved packing the leases tightly with wells on 5- to 10-acre spacing. While this has been successful in generating initial production, we cannot be sure that this tighter spacing won't lead to steeper, more persistent declines or other problems.
The transition of a well from a steeper decline to a more gradual decline has much to do with the amount of area it has to draw on and how easily it can draw from that area. If the spacing is too tight, the well may not transition much to a more gradual decline at all. Also, as more and more oil and gas are produced, the void space these volumes leave behind becomes increasingly filled with formation water that migrates in from adjacent areas and which must be produced along with the oil and needs to be disposed of. So as the production rate keeps falling, the operating expenses (per barrel of oil produced) rise in tandem - which brings us to our next point.
The Reasonably Prudent Operator Standard
Under the terms of the trust agreement, Sandridge is held to what is called the "reasonably prudent operator standard." Here's an excerpt describing it from the S-1 filing:
Sandridge is required under the applicable conveyance to act as a reasonably prudent operator with respect to the Underlying Properties under the same or similar circumstances as it would act if it were acting with respect to its own properties, disregarding the existence of the royalty interest as a burden affecting such properties.
Basically, it means Sandridge is required to keep producing the properties even if it is losing money due to the fact that it signed away a big chunk of its revenue interest. This provision is meant to protect investors. At the same time, however, it serves as a reminder that Sandridge can still shut-in any of the wells that become uneconomic based on the reasonably prudent operator standard.
And, given that many of these wells produce marginal volumes of oil and significant volumes of water (that needs to be disposed of), it may not take much longer before some of the wells become uneconomic under the reasonably prudent operator standard and could therefore be shut-in.
If this were to happen, the effect would be to increase the "steepness" of the field-wide decline rate, which could offset any effects from the individual wells transitioning to a flatter decline (if that were actually to happen).
In sum, the Sandridge Permian Trust is most likely overvalued. There is a relatively small chance that the decline rate could actually flatten out and therefore justify the current valuation, but given the sizable risks that it could fall substantially short of this, it makes little sense to hold on to this investment at its current price. And - again - we're assuming a case where an investor has hedged commodity prices. If oil prices go up, of course this will go up, too - a rising tide lifts all boats. But if you're looking for something that will perform well in a hedged portfolio or that will outperform other oil and gas weighted investments, the Sandridge Permian Trust is not well-suited for these purposes.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
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