Permian Basin Royalty Trust: Small-Cap Alpha

| About: Permian Basin (PBT)
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Summary

Permian Basin has experienced outsized market gains since early December against the overall cost of WTI on the NYME.

OPEC production cuts appear to be 90% on schedule through January according to IEA estimates. Estimates for February are still outstanding.

WTI fell briefly into correction territory in the first week of March as EIA estimates of US oil inventories were less than 3% below an all-time high.

PBT continues to surge in the current environment where contango and drilling efficiencies create a fecund investment environment for at least the time being.

The Permian Basin Royalty Trust (NYSE:PBT) operates within the same legal parameters as any other of the more familiar trust arrangements out there with a grantor, property, a trustee and a beneficiary. A royalty trust merely forms a corporate entity that both owns and controls the mineral rights of a designated property for the sole purpose of distributing the income generated from the sale of the property's assets to its shareholders. In PBT's case, those properties include the Waddell Ranch in Crane County, Texas which is in the heart of the Permian Basin, an ancient sedimentary formation that straddles the western border of Texas and the southeastern corner of New Mexico that first came into production in the 1920s.

The Waddell properties contain roughly 78,700 gross acres, half of which producing, where most of the Trust's proven reserves to date reside. Proven reserves include 1.357 million barrels of oil and 6.3 million cubic feet (MCF) of gas with a total net cash flow of $64.17 million and $42.33 million respectively, through the end of December 2016. The Texas Royalty properties also contained in the Trust are scattered about 21 counties in the Midland and Matador sections of the Permian Basin as well as fields in another 12 disparate counties spread across the northern, eastern and southern portions of the state.

The Texas Royalty properties contain about 303,000 gross, a sixth of which are currently producing, acres according to company filings. Proven reserves in the Texas Royalty properties include 3.098 million barrels of oil and 2.218 Mcf of gas with a net cash flow of $124.102 million and $55.745 million respectively, also through the end of December 2016. Together, the proven reserves of PBT come to 4.455 million barrels of oil and 8.518 Mcf of gas over the reporting period.

The nuts and bolts of shareholder payouts from Trust assets is pretty straight forward:

  • The main source of future cash flows is a computation under Financial Accounting Standards Board (FASB) reporting rules using an unweighted arithmetic average of the first day of the month benchmark price for each month of the reporting period. No pulling punches here: The unit measure payout to Trust shareholders correlate closely to the prevailing price of both oil and gas for any given reporting period. That measure has witnessed a good deal of price volatility since 2014, mirroring the price volatility of oil and gas prices on the New York Mercantile Exchange (NYME) over the period. The average oil and gas prices for 2016 came to $42.75 per barrel and $2.48 per Mcf, down measurably from the average of $50.28 per barrel and $2.59 per Mcf in 2015-and just short of half the $94.99 per barrel and $4.35 per Mcf prices in 2014.
  • Since the Trust payments to shareholders are based on sales of a depleting asset, a portion of the distributions comes in the form of a return of capital which is tax-free, rather than a return on investment which is taxed at capital gains rates. Depletion rates at the Trust level in 2014 amounted to just over 12% for oil and just over 8% for gas through December on a year-over-year (YOY) basis. In 2015 the depletion rate increased to over 14% for oil and soared to over 31% for gas YOY. By 2016 the depletion had fallen measurably to just over 3% for oil and just under 6% for gas YOY. The depletion allowance is 15% of gross annual income.

And then there is market appreciation. While PBT has closely followed the market path of West Texan Intermediate (WTI) crude since 2012 when benchmark data became available, the two positions began to pull apart rather abruptly since the first days of December 2016. OPEC had just concluded an historic meeting on the 30th of November in Vienna and announced an output cut target of 32.5 million barrels per day (b/d) for member countries, down from current production levels spilled over at about 33.8 million b/d, according to International Energy Agency (NASDAQ:IEA) data. The cut amounted to taking about 500,000 to 600,000 barrels a day-about 1% of global supply-off the market for a six-month period starting in January.

While the baseline OPEC production level had moved decidedly up during the course of the year, supply in the 97 million b/d global market was estimated to exceed demand by about 1% to 2% throughout much of 2016. OPEC's production cut, if it remained on course-a big if in many circles-had the potential of bringing the surplus and the resulting downward pressure on global prices under control.

While OPEC has cut production targets for the group three times in 2008 in the face of plummeting demand after the outbreak of Great Recession of 2007 and also in the 1990s in the face of the Asian financial crisis, the cartel maintained a poor record for keeping its members in line with production cuts. Cheating by member countries proved difficult to overcome as sanction formulas to meet such contingencies were largely absent from the process. Similarly, the Vienna agreement lacked an enforcement mechanism.

And then there was that elephant in the room, namely U.S. production-which was not a party to the Vienna agreement. With world oil prices on the rise, wouldn't this bring US shale back into the equation and possibly offsetting any declines in global supply? No matter, market expectations moved in a decidedly different direction. Hedge funds and institutional players dramatically increased their long positions on Brent crude to the highest levels since 2011, according to ICE data in the weeks that followed OPEC's Nov. 30 Vienna announcement.

The first day of December saw WTI inch above the psychologically important market threshold of $50/barrel for the first time in over a month and what would turn out to be its first sustained period above $50/barrel since July 2015. PBT began to soar. On Dec. 2, the share price stood at $7.21. By Feb. 17, PBT had hit $9.63 for a 33.67% romp for the period. The share price has since fallen back to $9.19 through Friday's market close-still locking in a 27.46% gain through Friday's market close. Much of the current decline has resulted from the current pullback in oil prices as hedge funds and institutional money began winding down some of their outsized long positions. WTI dropped below $50/barrel on March 9, where it currently remains.

The reason for the current market slide comes mainly from nine consecutive weeks of increasing U.S. inventory levels that went from 483.109 million barrels in the week ending Jan. 6 to 528.393 million barrels through the week ending March 3, according to EIA data. The realization sent the price of WTI into correction territory with a 10.20% market move. With the EIA estimate slipping slightly to 528.156 million barrels last week, down a mere 8,209 barrels, WTI gained almost a dollar a barrel at Friday's market close on the news.

In the present context, PBT cannot escape market volatility in its entirety. But what the issue has working in favor is only partially influenced by current market expectations. PBT production was understandably high in 2014. The average price of WTI in the first six months of the year was just over $100/barrel. The peak for the year happened on the 20th of June at $107.26/barrel. Oil production hit 496.193 million barrels for the year. As the price for WTI began to fade, so too did production levels. By the end of 2015, oil production had fallen to 344.795 million barrels, a drop of almost 31% YOY. Interestingly, Trust oil production increased sharply by the end of 2016 to 490.431 million barrels-a 42.24% increase at the same time when the price of WTI on the NYME hit its lowest post of the period at $43.50/barrel. Why?

The cost of producing oil had fallen dramatically over the period in question. In 2014, average production costs in the Waddell properties where the majority of the Trust's reserves reside, fell from $20.66/barrel to $6.79/barrel -- just over 67%. From the end of 2015 through the end of 2016 those costs had fallen 59%. For the Trust properties as a whole, production costs had fallen just over 36%. During much of 2015 and into early 2016 when WTI prices foundered, drilling continued but actual production slowed dramatically. Wells were drilled in the rock, which comprises the bulk of the cost of production, but the steel tubing and final production remained uncompleted.

Such wells are called DUCs -- drilled but uncompleted. These holes in the rock would await the recovery of prices, it was hoped, later in the year. Break-even production costs had fallen from $64/barrel in 2014 on core Permian acreage to about $44 by the end of 2016. In the Midland County, break-even costs have fallen even further, from $65/barrel to $29/barrel, according to the Norwegian energy consultancy, Rystad. Rystad further estimated that 6,000 DUCs were drilled in the course of 2015 through mid-2016 that are now being brought into full production.

Oil futures are still priced higher than spot prices, a scenario referred to in industry jargon as contango. Contango provides traders with strong market incentives to store rather than sell crude into the market-which is why U.S. inventory stocks are close to an all-time high. Contango is also reflective of supply being out of balance with overall demand in the greater economy. For more than two years now, the price of oil delivered in the future has been higher than the spot market, which has weighed heavily on the market-not to mention the economy as a whole. The OPEC initiative brought hope to many that the balance between supply and demand would once again move toward a rough balance.

Our current contango scenario is the second longest such period since 1987, according to S&P Dow Jones data. The only other period that was longer came as a result of the financial crisis between November 2008 and October 2011 when demand plummeted and OPEC cut production three separate times to soak up the slack. The contango scenario coupled with outsized reductions in production costs constitutes the main ingredient of PBT outperformance. That window will not last long.

Disclosure: I am/we are long PBT.

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.