As those familiar with my articles know, I forecast the value and future distributions of various oil and gas trusts. This article presents a comparison of fifteen trusts, given forecasts of their future performances.
Quarter in Review
Summer’s over petrophiles. Let’s get back to work and run down the numbers on all our favorites trusts.
Natty gas investors have had a rough 2018. As expected, weakness in gas prices has been a large factor for sagging gas trusts, but actions by producers have led to substantial, unanticipated pain. San Juan Basin Trust (SJT) traded producers and coughed up all its earlier gains. $5 never seemed so low. ECA Marcellus Trust I (ECT) also traded producers and has spent the summer looking up at $2. And NDRO not only has a new producer, but was renamed Permianville Royalty Trust (PVL), which sounds like an inside joke. Of course, then there’s Hugoton Royalty Trust (OTCQX:HGTXU), which voluntarily delisted itself and closed recently at $0.40.
However, it’s a different story for black gold. As investors have surely noticed, recent market prices for the oil trusts are exactly what 2017 longs “told you so”. MV Oil Trust (MVO) is solidly above $11. BP Prudhoe Bay Trust (BPT) dropped a dog of a distribution and is still at $36. Whiting USA Trust II (OTC:WHZT) is at $2.80 after paying out two monster 30 cent distributions. Even SandRidge Permian Trust (PER) is holding at a let’s-take-that-cruise-baby price of $2.72.
This Forensic Accountant wasn’t as active as desired this year, but that didn't stop execution on a number of trades highlighted late last year. What started as a long position on SandRidge Mississippian Trust I (SDR) at $0.75 turned into a short on SandRidge Mississippian Trust II (SDT) over $2. Both put money in the “2019 cabana fund”. BPT options at $25 turned out to be quite the bargain – though I might have spent too much time in the pool and sold at only a modest gain. And while my Pacific Coast Oil Trust (ROYT) position has kicked back a few pennies per share, selling $2.50 calls on ROYT was the winning strategy for this trust in early 2018 and staying long another winner in summer 2018.
But just because the oil trusts are up doesn’t mean that the opportunities for long positions are over. There’s plenty of possible action on the table – and here are some of the things I’m looking at:
- If BPT can sort out it’s production malaise it could leave $36 in the dust. But go long?
- The ROYT fanboy network keeps dreaming of $3+. It's possible, but only if the capital program works out. Will it?
- Why do the SandRidge Trusts seem to get caught up in SandRidge’s management disputes? Does it matter?
- Trust darling WHZT is finally moving towards overbought, but could still rock at current oil prices.
- VOC Energy Trust (VOC) is beautifully volatile. My $5.30 entry hasn't hit.
Let’s get to the numbers.
Two Ways to Forecast Value
I compute two different estimates of value for each trust. The first is a fundamental valuation that uses an engineering-style model and discounted cash flow (DCF) analysis. The second is an adjusted NPV-10 based on previously published reserve reports.
The model/DCF method estimates future distributions by developing bottom-up forecasts for each revenue and cost component of a trust's distributable income statement.
- Production is forecast based upon historical well depletion rates and expected future well completions and workovers; published reserves are ignored
- Sales prices are forecast as NYMEX Henry Hub (HH) and West Texas Intermediate (WTI) futures, adjusted for historical spreads
- Costs are forecast individually based on prior costs, revenues, production and inflation
- Share subordination and unique passive income streams are explicitly considered
- Termination date and terminal value is based on the specific terms in each trust’s agreement, the expectation that the proprietor will act only in their own best interests over time, and forecast production and sales prices, not on the reserve report
Reserve Report Method
The reserve report method adjusts the estimate of NPV-10 in each trust's reserve reports for updated price and production information.
- Production since the date of the reserve report (if any) is subtracted from published reserves
- Oil and gas prices are updated to reflect current HH and WTI prices and historical spreads
- Costs, as provided by the reserve report, are prorated by remaining production
- Trust administrative costs are subtracted
Although both methods may appear to be similar, there are key differences that provide strengths (or weaknesses) to each approach. Trust reserve reports are, in theory, based on detailed well production data. However, their assumptions are impossible to verify and they frequently exclude key costs and other considerations. The model is based only on public information and is fully transparent - if you would like to know a trust-specific assumption, please ask.
Gas Settles in Under $3, WTI Keeps it Wild
Let’s talk futures pricing. HH is teasing $3.20/mcf as we head into the heating season. But NYMEX futures suggest supply trumps demand and doesn’t have gas above $3 again (ever!). WTI futures are similarly bearish, with prices declining from current highs back to a modest $58/bbl in 2023. But not to bash too hard – futures suggested oil would be at $50 by 2020 just a few months ago.
Fig. 1: Oil and gas prices used by the model and implied oil price premium. Source: NYMEX and author's analysis.
October 2018 Valuations
The table below presents a comparison of fifteen trusts based upon valuations using the two methods. The table is divided into five sections. In the first section, trusts are ranked according to the model's forecast internal rate of return (IRR). For comparison, the risk-adjusted rate of return that I use for Fair Value (FV) calculations is also shown here.
The second section presents four different valuations: a recent closing market price and three net present value (NPV) estimates, two using 10% discount rates for the model and reserve methods and the third discounting the model's valuation at FV%.
The third section of the table presents the ratios of the market price to the three NPVs. I consider trusts with FV-to-market-price-ratios (column c) of less than 1.0 to be candidates for long positions, while reserve-report-NPV-10-ratios (column e) over 4.0 are one indicator that I use to identify short candidates. The fourth section compares 12-month forward and trailing yields and the fifth provides the oil/gas revenue mix, expenses and other details.
Fig 2. Trusts ranked by IRR. Source: Google Finance, Trusts' SEC filings, and author's analysis. Columns with an "M" are derived from the model's forecast; those with a "T" from the trust reserve reports.
Predominantly Gas Trusts
Smell that? If your nose is twitching, you’re either working in a swamp, or you are too dang close to one of the six trusts that derive their income primarily from natural gas.
- Based on reported numbers and a horrific market price decline, the model says San Juan Basin Royalty Trust (SJT) is a buy up to $6. But the new proprietor can’t seem to report the production numbers on a timely basis and I’m not buying the excuses. Plus, there’s a CapEx pressure wave heading down the pipe that could cut price support even further.
- ECA Marcellus Trust I (ECT) is hardly any better. The price is now well under the $2 target that I postulated last December and now shows a decent trailing yield of 14%. But deep down inside, something smells funny. Last quarter’s results showed an exceptional production decline and the model says that, with a 3.5% long term yield, it’s neck-and-neck with U.S. Treasuries. May be production rebounds and ECT hits $2.20… but may be it doesn’t and there’s a much better price in January.
- The eponymous Sandridge Mississippian Trust II (SDR) was a terrific long at $0.80, but at the current market price of $1.32, it’s hardly a value buy. The stink here, though, is SandRidge Energy (SD), which has a host of problems and a similar name. If Dominion Black Warrior Trust taught us anything, it’s that investors who don’t pay attention to what they are buying are a wonderful source of disposable income (for me). I’m looking for another 10% drop before I start accumulating.
- Sandridge Mississippian Trust I (SDT) is déjà vu: the model says it will underperform the similar SDR, but currently trades at a mild premium. It was a very nice short at $2.20, which I closed two weeks later at $1.80. Nom nom nom. I’m keeping my eyes out because there’s a chance folks rage buy this garbage again this winter. You know who you are.
- Mesa Royalty Trust (MTR) is a mid-to-poor offering. With a negative long term yield, the model says avoid. And since I still can’t get the monthly totals to equal the quarterly reports, I’m thinking the stink ain’t last week’s cheese.
- Hugoton Royalty Trust (OTCQX:HGTXU). Oooh the burn. If XTO Energy maintains its CapEx program, this trust will be dug in so deep it will never pay again. Ever. And then there’s the litigation risk, which I didn’t bother to include in the model because it’s hard to be worth less than $0. Longs can take solace that it’s likely to be a slow death – the last whimpers might not happen until 2022. There’s always a chance?
Perpetual Oil Trusts
Four trusts have income primarily from oil production and have no fixed termination date (so-called "perpetual" trusts):
- For California-based Pacific Coast Royalty Trust (ROYT), there is plenty of optimism. Despite market prices near 52-week highs, increasing oil prices and the potential recovery of production could set this trust on a run past $3 or significantly higher. But production has been disappointing and there’s the potential for another CapEx wave that could cause longs to sell off in a big way. Which will it be? Of the suspense! I’ve taken some profits on an outsized position and won’t look to add unless I see a significant retrenchment under $2.50.
- Permianville Royalty Trust (PVL) should be just fine despite the previous proprietor declaring bankruptcy. Last December, I called for $3.60 and then an eventual drop to $2.70, or below. Jury’s still out on the second count.
- Permian Basin Royalty Trust (PBT) offers a paltry 2.0% long term IRR. Holding this is a bet on long term oil. Why bother?
- BP Prudhoe Bay Royalty Trust (BPT) is the granddaddy of all trusts with wells in Alaska. It is grossly overvalued. However, if you say that’s news to you: liar, liar, pants on fire. BPT has a huge short interest and is set to drop at least a few more beefy distributions before it dies.
Terminal Oil Trusts
Five trusts are terminal oil trusts:
- Whiting USA Trust II (OTC:WHZT) is OTC and illiquid, which is why it is king of the hill for value… and volatility. Two monster distributions have put so much money in the bank, I’m thinking of buying Venezuelan Petros. But longs should take care because the market to sell isn’t always there and, more importantly, there’s a potential spike in CapEx that could hit in the next two quarters. I’m holding a full position and expect to sell into market strength when the next large distribution hits, knowing that may not be until 2019.
- Chesapeake Granite Wash Trust (CHKR) has a 0.2% yield – a real value stinker. But I have this guilty pleasure… to sneak into small positions of trusts like this and then sell into the pre-distribution market pressure. With a 16.5% forward yield, I’m thinking price action could hit $1.75 – that’s not enough to buy at current levels, but at $1.50….?.
- Sandridge Permian Trust (PER) is a SD trust with wells in west Texas. In December, I called for gains of 10%. I was wrong by 30%. I’m looking to rebuild a position, though I can wait for $2.50 or lower.
- VOC Energy Trust (VOC) gave up the dog of the month title back to MVO. Chronically overvalued by the market, one day this trust may make for an early retirement. Today, I'm thinking there's a greater fool out there. The $5.30 price level seems reasonable to me.
- MV Oil Trust (MVO) is an MV Oil and Vess-operated trust with wells in Kansas and Colorado. Nothing like oily optimism to pump up this overvalued dog
Disclosure: I am/we are long WHZT, ROYT. 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.