Every year, in its annual 10-K filings, BP Prudhoe Bay Royalty Trust (BPT) provides an estimate of expected total future cash flows, their present value, and an estimate of the termination year of the Trust. Although the Trust does not provide details regarding all estimates it uses to do this calculation, it does provide details on some of them, while the remaining ones can be inferred to determine how the estimates are made.
With 21.4 million units outstanding, estimated total future cash inflows of $154.662 million equals $7.23 per unit, while the discounted present value of these payments (at 10% p.a.) of $138.541 million is equal to only $6.47 per unit. Investors are currently willing to pay about $27 per unit, or 4 times this amount. This is rather astounding considering actual future payments may be even less than what BPT indicated in its 10-K, as I will explain below.
Modeling BPT's Estimates
Utilizing a combination of explicit assumptions made by BPT in its projections and publicly available data, as well as a bit of estimating on my part, I have developed the following model to determine the parameters BPT must have used to arrive at its estimate of $7.23 in future cash flows:
The sources of the figures I used in the model are as follows:
- The WTI figure of $65.56 and the Chargeable Cost amounts for each year are directly from BPT's 10-K.
- The Cost Adjustment Factor is based upon the change in the CPI index. Specifically, Section 4.5, p. 10 of the Overriding Royalty Conveyance dated February 28, 1989 states: "The Cost Adjustment Factor shall mean the ratio of (1) the Consumer Price Index published for the most recently past February, May, August or November, as the case may be, to (2) the Consumer Price Index published most recently prior to the Effective Date." BPT's most recently published factor was 1.942 for the quarter which ended Sept. 30, 2018. This was based upon the CPI at August 31, 2018. At November 30, the factor should be 1.9412 based upon a minor decrease in the index during the prior three months. The CPI decreased a further .3% in December, which would result in a December 3, 2018 CPI factor of 1.9354. I have assumed this is the factor that BPT used. BPT uses the same factor through the entire period of the projections.
- I estimated $2.30 per barrel for production taxes with WTI at $65.56. I did this by doing a bit of interpolating from two distributions in the past year; production taxes were $2.21 in Q1 '18 when WTI was $62.96, while in Q2 production taxes were $2.41 with WTI at $67.85.
- With respect to production volumes until termination of the Trust, the 10-K states (on p. 50) that: "Net proved reserves of oil and condensate attributable to the Trust as of December 31, 2018, 2017 and 2016, based on BP Alaska’s latest reserve estimate at such times and the 12-month average WTI prices for 2018, 2017 and 2016, were estimated to be 15.772, 9.070, 9.376 million barrels." In other words, the 15.772 million barrel figure at December 31, 2018 is the total on which BPT holders are expected to receive a royalty distribution prior to termination in 4 years, so the issue becomes how to distribute that production over annual time periods. I allocated the production assuming an annual 7% decrease. The actual decrease from 2017 to 2018 was in excess of 7%, so this is a reasonable assumption. For 2019, I did a quarterly allocation, reflecting the typically lower Q3 distribution. For the remaining years, annual projections are provided.
The cash flows calculated by my model are almost exactly the same as the projections provided by BPT; I calculated total cash flows of $153.962 million compared to BPT's estimate of $154.662 million. My per unit cash flow calculation of $7.19 compares to BPT's implied amount of $7.23. Minor differences in estimates of the Cost Adjustment Factor, production taxes and/or the timing of production could easily account for this slight difference.
An Unrealistic Cost Adjustment Factor
In its projections, BPT uses the unrealistic assumption that there is no inflation, and therefore no increase in the CPI or BPT's resulting Cost Adjustment Factor. When these annual projections are done for the anticipated remaining life of the Trust, which at times has had to consider periods of 20 years or more, BPT also models no increase in the price of WTI, another unrealistic assumption. However, it is impossible to accurately project either of these items over long time periods and to a large extent any increase in either one would be cancelled out by an increase in the other one. As a result, this approach is generally a reasonable one.
However, there are now only a few years remaining in the Trust, and we have a situation where current WTI is appreciably lower than the $65.56 (last year's average) in the model while we can be confident there will be some inflation. I therefore tweak the model to show a more realistic CPI increase of roughly 2% per year rather than 0 over the remaining Trust term:
There are two important impacts to note. The first is that total future payments decrease by about $1.38 per unit to $5.81. The second impact is that the Trust stops making payments in only three years rather than four years.
Adjusting the Model to Reflect Estimated Q1 Payment
The first quarter of 2019 is almost over, so it is possible to make a reasonably accurate projection of the likely payment for the quarter to be announced in early April. WTI averaged $51.38 in January, $54.95 in February, and with March half over, will likely average about $57, resulting in an average for the quarter of about $54.50. As a result, I further tweak the model:
Of immediate concern to investors should be the estimated distribution of only $.35 for the current quarter compared to last quarter's distribution of a bit over $1 per unit. There is also a major impact on expected total future distributions, which decrease by an additional $.56, to $5.25.
The Bull Case: Increasing WTI $5 Per Year
Finally, I provide below what I consider to be a very bullish scenario for BPT. I continue to assume that WTI will average $65.56 for the remaining 3 quarters of 2019, but that it increases by $5/ brl. each year thereafter.
Production tax calculations are complicated, were recently changed, and there are proposals being considered in the Alaska legislature to increase them. As a result, my production tax estimate in the table below, which vary according to WTI price changes, are only rough approximations, but I believe they are conservative:
This bullish scenario has WTI reaching $90 per barrel in 2024, and even then it would be the final year during which the Trust makes payments. Furthermore, total future payments would be only $9.59, with the NPV of these payments being considerably less.
Using either BPT's projections or any other reasonable set of assumptions, there is no question that BPT is greatly overvalued. With the stock trading at about $27 per unit, the only real question is whether it is overpriced by a factor of 5-6 times or "only" 3-4 times. Furthermore, when the April distribution of about $.35 is announced, many "yield" investors are likely to exit their BPT investment at that time. Due to both of these factors, prudent investors should consider minimizing the risk of becoming "April fools".
Disclosure: I am/we are short BPT. 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.