SandRidge Mississippian Trust II Is Dissolving, Leaving Investors With Large Losses And Important Lessons
Long-Term Horizon, Value, Contrarian, Growth At A Reasonable Price
Seeking Alpha Analyst Since 2010
My name is Xinyun Hang, though I go by Charles Hang. I'm a value investor who focuses on companies with high free cash flow yields, especially those that are trading at a low EV/FCF (enterprise value to free cash flow) ratio. I live in St. Louis, Missouri, where I am employed as a data quality engineer and study engineering as a graduate student.
Summary
- SandRidge Mississippian Trust II is dissolving this year because its distributions have fallen below their minimum threshold.
- The trust still has a few more distributions to go before its dissolution.
- Even so, total losses for those who invested in the trust's IPO are likely to be over 60%.
- These losses offer valuable lessons for investors in IPOs, oil and gas companies, and high yield stocks.
SandRidge Mississippian Trust II (SDR) (OTC:SDRMU) announced in late January 2020 it would dissolve by the end of 2020.
SDR owns oil and natural gas royalty interests in the Mississippian formation of southern Kansas and northern Oklahoma. These interests entitle SDR to royalty payments out of the income from 273 oil and gas wells drilled by SandRidge Energy (SD), the trust’s sponsor. Most of this royalty income is then distributed to the owners of the trust’s units (shares).
Once the trust is dissolved, SandRidge Mississippian Trust II’s unitholders will not get any more distributions. This will leave many of them, including investors who bought units in the trust’s IPO, with a large loss on their investment. This loss offers important lessons for future investors, especially investors in IPOs, the oil and gas industry, and in high yield stocks.
SandRidge Mississippian Trust II’s Dissolution
The trust agreement governing SandRidge Mississippian Trust II states when the trust will be dissolved. According to SDR’s first quarter 2020 quarterly report:
…the trust agreement governing the Trust requires the Trust to dissolve and commence winding up of its business and affairs if cash available for distribution for any four consecutive quarters, on a cumulative basis, is less than $5.0 million.
Source: SandRidge Mississippian Trust II Q1 2020 10-Q
This $5.0 million threshold has been reached:
As cash available for distribution for the four consecutive quarters ended December 31, 2019, on a cumulative basis, was approximately $4.392 million, the Trust commenced its winding up procedures beginning at the close of business on February 14, 2020.
Source: SandRidge Mississippian Trust II Q1 2020 10-Q
Unitholders will get a little more in distributions before the dissolution:
Pending the sale or sales of the royalty interests, and subject to the effective date and other terms of such sales, the Trust anticipates that it will continue to receive income from the royalty interests and will continue to make quarterly distributions to unitholders...
Source: SandRidge Mississippian Trust II Q1 2020 10-Q
Once the trust is dissolved, the unitholders will also get a distribution from the sale of the trust’s assets:
…the Trustee is required to sell all of the Trust’s assets…and distribute any net proceeds of the sale to the Trust unitholders after payment, or reasonable provision for payment, of all Trust liabilities…
Source: SandRidge Mississippian Trust II Q1 2020 10-Q
SandRidge Mississippian Trust II’s Past and Future Distributions
SandRidge Mississippian Trust II’s units were first sold to the public on April 17th, 2012 at a price of $21.00 per unit. Since then, unitholders have gotten the following distributions:
Year |
Distributions Per Unit |
2012 |
$1.363 |
2013 |
$2.310 |
2014 |
$2.015 |
2015 |
$1.139 |
2016 |
$0.395 |
2017 |
$0.233 |
2018 |
$0.207 |
2019 |
$0.118 |
Q1 2020 |
$0.014 |
Total |
$7.794 |
Source: SandRidge Energy 2014, 2017, and 2019 10-K Annual Filings and Q1 2020 10-Q Quarterly Filing
It is hard to say how much more unitholders will get, but it probably won’t be much. The average oil, natural gas liquid (NGL) and natural gas prices SDR received for its production in the most recent quarter, the first quarter of 2020, are below:
Source: SandRidge Mississippian Trust II Q1 2020 10-Q
SDR’s oil, NGL, and natural gas volumes that quarter are here:
Source: SandRidge Mississippian Trust II Q1 2020 10-Q
By combining SDR’s volumes and pricing, we can calculate that about $0.490 million of the trust’s Q1 revenue came from oil. This is equal to 9 thousand barrels (MBbls) of oil multiplied by $54.48 per barrel. This was about 27.8% of the trust’s $1.761 million in total revenue.
Similarly, about $0.604 million, or 34.3% of total revenue, came from NGLs. This is equal to 37 MBbls multiplied by $16.33 per barrel.
Finally, $0.685 million, or about 38.9% of total revenue, came from natural gas. This is equal to 445 million cubic feet (MMcf) of natural gas multiplied by $1.54 per thousand cubic feet (MCF).
These three percentages don’t add up to exactly 100% because of rounding. However, they show SDR received about 62% of its Q1 income from oil and NGLs. NGL pricing is tied to oil pricing. Since oil prices are now much lower than $54.48 per barrel, SDR’s oil and NGL revenues will probably be much lower in Q2 2020.
The trust’s natural gas income may be higher in Q2 than in Q1 since natural gas prices have risen from $1.54/Mcf. However, natural gas only made up 38.9% of Q1 revenues. Thus, that increase probably won’t offset the drop in oil and NGL income. The trust’s Q2 2020 distribution is almost certain to be lower than its Q1 distribution of $0.015 per unit.
Oil prices will probably stay below $54.48 a barrel all year. Thus, SDR’s quarterly distributions will probably never go over $0.015 per unit again. This is especially true since SDR’s production volumes will fall as the trust depletes its oil and gas reserves.
Beyond additional distributions, unitholders can also look forward to proceeds from the trust’s liquidation. Those proceeds probably won’t be large. The trust’s main assets are its royalty interests. These interests will still have some value since the associated wells will keep producing oil and gas. Thus, royalty holders will keep getting payments. However, due to the fall in prices, there are no doubt many cheap oil and gas assets on the market being sold by distressed owners. In that context, the royalty interests will probably not sell for much.
For simplicity, we will assume SDR’s remaining distributions, including its final liquidation distribution, will be equal to the current unit price of $0.14 as of 7/22/20.
Losses for SDR’s IPO Investors
This assumption lets us calculate the total loss that investors who bought SDR units at the IPO will end up incurring.
This assumption is probably optimistic since SDR unit prices have historically been higher than total future distributions. In other words, unit buyers have not gotten enough in distributions to let them break even on their purchase prices.
For example, SDR units traded for $0.96 per unit at the start of 2018. Since then, SDR has distributed $0.339 per unit. People who paid $0.96 per unit in January 2018 need SDR to distribute another $0.621 per unit before it dissolves this year to break even. That probably won’t happen, given that the last quarterly distribution was only $0.015.
Similarly, SDR traded at over $1 per unit at the start of 2019. Since then, SDR has distributed only $0.132 per unit. It is even more unlikely SDR will distribute $0.868 per unit or more this year. Thus, people who bought units in January 2019 at over $1 probably won’t be made whole.
I can only speculate why people bought SDR units at such high prices in 2018 and 2019. It’s possible they thought oil and gas prices would go up enough for SDR to be a good investment. However, I suspect they bought based on the trust’s dividend yield. At the start of 2018, the trust’s distributions in the past 12 months totaled $0.233. At $0.96 per unit, the trailing dividend yield would have been 24.3%. Similarly, at the start of 2019, the trailing dividend yield would have been around 20%. Investors who didn’t look at the sustainability of future distributions may have bought units thinking they could get that yield for a long time.
That belief was sadly mistaken. Despite that, I suspect there are speculators today who are bidding up SDR’s unit price based on its trailing dividend yield, which is over 40%. They might not realize that trailing yield is based on the past 12 months of distributions, which are unlikely to repeat themselves. They also might not realize the trust is dissolving in less than a year.
SDR has a history of being priced so high buyers do not get enough distributions to break even on their investments. In that context, I think it’s optimistic to think buyers at today’s unit price of $0.14 will get $0.14 in distributions before the trust dissolves. Along those lines, by using that price to estimate the trust’s remaining distributions, we are probably describing the happiest possible outcome for current unitholders.
Under that optimistic assumption, SandRidge Mississippian Trust II’s total lifetime distribution per unit will be around $7.924:
Year |
Distributions Per Unit |
Total Historical Distributions |
$7.794 |
Estimated Remaining Distributions (7/22/20 Unit Price) |
$0.14 |
Estimated Lifetime Distributions |
$7.934 |
IPO Price |
$21.000 |
IPO Investor Loss |
62.2% |
Even under optimistic assumptions, an investor who bought SDR units at the IPO price of $21.00 will have lost over 60% of their investment once the trust dissolves.
Lessons
SandRidge Mississippian Trust II’s unfortunate history offers valuable lessons:
1/ Investing in IPOs often leads to poor outcomes. For example, a recent Bain & Company analysis showed that “over five years, two-thirds of global IPOs underperformed their established, publicly listed peers, with a median 46 percentage points lower total shareholder return (TSR).” Another analysis attributed this underperformance to “a set of firm characteristics related to investments, internationality, liquidity, and leverage.”
Regardless of the reason, IPOs do generally underperform over both the short term (1 to 2 year) and long term (3 to 5 year) timeframes. SandRidge Mississippian Trust II was just a particularly dramatic example of this underperformance.
2/ Oil and gas prices are volatile, which can cause serious losses. In just the past 13 years, we’ve had three oil price crashes:
Source: Macrotrends Oil Price History Chart
SandRidge Mississippian Trust II’s IPO was in 2012, when prices were almost $100 per barrel. Prices began falling two years later and have not risen that high since. This is probably the most important reason why SDR IPO investors will probably end up losing 60% or more of their investment once the trust dissolves.
3/ Not only are oil and gas prices volatile, but the oil and gas industry might not be able to generate significant returns for shareholders. In May 2016, Tom Ward, SandRidge’s founder, described how the industry’s “dirty little secret is you can’t really spend within cash flow and grow production.”
Investment advisor Peridot Capital Management’s blog described that statement’s implications:
What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.
………
This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.
Source: “Chesapeake and SandRidge Alum Tom Ward Just Admitted How Bad The Energy Exploration Business Model Really Is” Peridot Capital
I don’t believe all oil and gas common stocks are literally worth zero. Also, even if a producer such as SandRidge won’t generate returns for common shareholders, that doesn’t mean a royalty trust such as SDR can’t generate such returns. That said, a royalty trust holder does take on many of the same risks as an oil and gas company common shareholder. In that context, it’s worth considering if those risks are being adequately compensated for through high returns.
4/ Speaking of high returns, it is dangerous to invest in something for its high yield. Those who bought SDR’s units in its IPO were probably drawn to the trust’s yield. In the trust’s best year, 2013, investors earned a yield of over 10% on the IPO price.
However, this high yield concealed serious weaknesses in the trust’s operating model. Even at 2013’s maximum distribution levels, SDR’s unit holders would have required over 9 years of distributions to just break even on the IPO price. This would have required oil and gas prices to stay at around 2013 levels for over 9 years. It also would have required the trust’s 273 wells to continue producing at the same rates for over 9 years.
Such performance is implausible for oil and gas wells. A 2014 SandRidge investor presentation slide cited by a Motley Fool article shows first year production declines for wells in the Mississippian formation at the time were usually between 60 and 80 percent:
Source: “SandRidge Energy’s Worst Problem is Moderating” The Motley Fool
As the article’s title implies, this sort of steep decline was actually lower than the declines seen in SandRidge’s wells in 2012, when SDR had its IPO.
That said, I don’t know if there’s enough evidence to say SandRidge’s well decline rates imply SDR IPO investors were always going to lose money. SDR’s prospectus shows enough production was forecasted to give IPO investors positive returns. These forecasts no doubt considered historical decline rates. One reason SDR production declined faster than expected was because of the fall in oil and gas prices. This caused some of SDR’s wells to be shut down since it was no longer economical to produce from them. Such a fall in prices might not have been inevitable.
Regardless, part of SDR’s post-IPO underperformance was caused by production declines inherent to SDR’s wells. Part of it was caused by the fall in oil and gas prices. More analysis is needed to understand how much each factor contributed. As mentioned earlier, I think the fall in prices was the bigger contributor.
That said, I do think well decline rates were one of many factors many SDR IPO investors ignored in the search for yield. I suspect many such investors did not consider if the trust’s high yields were sustainable in the long term.
This mistake has implications today. Real estate investment trusts (REITs) and master limited partnerships (MLPS) are currently very popular because of their high yields. However, as my recent article about REIT Ladder Capital (LADR) showed, high yields can come with erosion in the underlying investment value.
Of course, this doesn’t mean high yields are always risky. Rather, it’s a reminder that a high yield shouldn’t keep investors from seeing those risks. There is a reason the term “yield pig” exists.
In conclusion, SandRidge Mississippian Trust II’s impending dissolution offers many lessons for investors. It’s unfortunate these lessons have only been made possible by over high losses for the trust’s IPO investors.
Analyst's Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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