On August 29, 2012, BP Prudhoe Bay Royalty Trust (NYSE: BPT) dropped an astonishing 17.86% in a single day to less than $78 per unit. Even more startling, BPT traded at $120 only twelve days prior. All in, BPT has experienced a massive drop of $43.23, or 36%, in only twelve days. This drop surprised a lot of holders of BPT units and left them searching for answers. What could possibly explain the drop? Even more importantly, are the wild price swings over or could the price plunge even further in the near future?
I can answer these questions. In fact, I answered them more than a year ago. On February 10, 2011, I wrote a two-part article about BPT. You can view the article here:
In these articles, I analyzed the potential future distributions to be made by the trust over the remaining lifetime of the trust under three scenarios, which I characterized as "pessimistic," "moderate" and "optimistic." Each scenario used a different assumption about future increases in the price of oil and inflation. My conclusion in all three scenarios was that BPT, which was trading for about $115 at the time, was massively overvalued.
Mine was hardly the only warning. Others performed similar analyses, and each came to the same conclusion. Read some of them here and here. And yet the price of BPT units did not go down. In fact, as mentioned above, the price actually went UP! How could this possibly be, I wondered.
How Could the Market Have Taken So Long To Recognize that BPT was Vastly Overvalued?
Most agree that the market, though far from perfect, is generally pretty good at setting asset prices. How could the market misunderstand not only the effect that an inevitable rise in Adjusted Chargeable Costs (described in my 2011 article) will have on future distributions but also the levered relationship between BPT's unit price and the price of oil?
My working theory has been that BPT has historically paid, and continues today to pay, extremely high distributions. At the beginning of this week, the backward-looking distribution rate was nearly 10% per year and is now significantly higher. Additionally, BPT has posted staggeringly high historical returns. Each of these facts makes BPT extremely appealing to dividend-seeking individual investors, particularly those investors who pick stocks primarily on the basis of dividend yield. The failure of these investors to dig deeper in their analysis was a huge mistake.
But individual investors are not always the most savvy bunch. The critical mistake such investors appear to make with respect to BPT is to assume that the "headline" distribution rate (i.e., 9%) is actually a true dividend. Depending on one's assumptions about future oil prices and inflation, however, most, and potentially all, of the distributions paid by BPT are not dividends at all; rather, they are a return of capital.
I believe that, in this yield-starved environment, the due diligence performed by many of these investors starts -- and stops -- at the fat distribution rate. This is a huge mistake. Put another way, BPT is held by a tremendous number of "yield pigs" of the type that Seth Klarman described in the book Margin of Safety, excerpted below.
There are countless examples of investor greed in recent financial history. Few, however, were as relentless as the decade-long "reach for yield" of the 1980s. Double-digit interest rates on U.S. government securities early in the decade whetted investors' appetites for high nominal returns. When interest rates declined to single digits, many investors remained infatuated with the attainment of higher yields and sacrificed credit quality to achieve them either in the bond market or in equities. Known among Wall Streeters as "yield pigs" (or a number of more derisive names), such individual and institutional investors were susceptible to any investment product that promised a high rate of return. ...
Junk bonds were not the only slop served up to the yield pigs of the 1980s. Wall Street found many ways to offer investors an enhanced current yield by incorporating a return of the investors' principal iinto the reported yield. "Ginnie Maes" ... are one such example. ... Every month owners of GNMAs receive distributions that include both interest income and small principal repayments. The principal portion includes contractual payments as well as voluntary prepayments. Many holders tend to think of the yield on GNMAs in terms of the total monthly distribution received. The true economic yield is, in fact, only the interest payments received divided by the outstanding principal balance. The principal component of the monthly distributions is not a yield on capital, but a return of capital. Thus investors who spend thentire cash flow are eating into their seed corn.
Sound familiar? Today, even more than the 1980s, individual investors are starved for yield. Since risk free securities offer virtually no yield whatsoever, the Fed has forced these investors to seek yield from riskier assets. Today's yield pigs are pouring into all sorts of investments that they don't fully understand and shouldn't be investing in, including BPT. These yield pigs are focused so much on the distribution rate (which Yahoo! Finance temptingly lists right under the stock price) that many have performed little to no diligence regarding, among other things, the amount of future distributions that this trust will make. Seemingly, their one and only source of information -- the distribution yield, which is a backward-looking indicator only -- has not changed a bit. "Yes, oil prices may drop. However, if that's my biggest risk then why would I ever sell? It will still be a great yielder, won't it?" they probably asked themselves.
But this week's 36% drop in the price of BPT has proved the folly of making an investment decision without understanding fully exactly what you're buying.
Why Another Big Drop Could Be Just Around the Corner
Let's now examine the second question I posed above, namely whether another big drop may be in store for BPT unitholders in the near future.
Some BPT holders probably think that this week's sell-off is an overreaction. That it's only a matter of time until BPT is back at $120. And maybe they'll be right. I don't have a crystal ball.
But I'd like to offer a word of caution to anyone who holds this belief. In fact, I would like to share with them the same message that I shared a year and a half ago - under all but the most optimistic assumptions, BPT is still extremely overvalued. Under my "moderate" scenario (which you can read about below), BPT should be trading at around $70 per unit - meaning the price could drop by another 10% from here.
And what if you have more pessimistic assumptions? Under the "pessimistic" scenario described in my original article, BPT should trade at around $57 per unit - which would equate to a staggering 26% drop from today's closing price! Buyer beware.
A Blast From the Past - BPT Buyers Beware Further Drops
I've pasted below my value estimates from February 2011 so that you can make your own judgment about what the future holds for BPT's unit price.
Now that we've run through the adjustments I've made to reflect higher reserves, lower production declines, a potentially longer life for the trust, and potentially higher (perhaps much higher) future oil prices, and now that we understand Adjusted Chargeable Costs and production taxes, we've got everything we need to estimate the fair value for BPT units. I calculated BPT's approximate value (I will spare you the math) under the following scenarios:
- Scenario #1 ("pessimistic"): Low growth in oil prices (2.5% annually) and moderate inflation (4% annually)
- Scenario #2 ("moderate"): Moderate growth in oil prices (3.5% annually) and low inflation (2.5% annually)
- Scenario #3 ("optimistic"): High growth in oil prices (5% annually) and low inflation (2.5%)
Note that, as previously discussed, all three of my scenarios use WTI oil prices that are significantly higher than the prices Mr. Lewis used when he calculated the per unit value of BPT at $40.85. Under my "pessimistic" scenario, WTI oil prices will break $100 per barrel in 2015 and will be at approximately $130 by 2025. Under my "moderate" scenario, WTI oil prices will break $100 per barrel in 2014 and will be nearly $150 by 2025. Under my "optimistic" scenario, WTI oil prices will break $100 per barrel in 2013 and will be nearly $180 in 2025.
Value of BPT under each scenario
After estimating future production and then deducting "Adjusted Chargeable Costs" and production taxes, I calculated the price at which BPT units would have to be trading in order for an investor to earn a 10% rate of return on his (or her) investment under each of the three scenarios discussed above.
And I was absolutely shocked by the results.
The chart below illustrates the annual distributions that a BPT investor would receive from now until the termination of the trust under the pessimistic scenario (2.5% annual growth in oil prices, 4% annual inflation):
Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 4.0% annually and an assumed increase in oil prices of 2.5% annually through 2027.
Under the pessimistic scenario, the total distributions paid out between now and the trust's termination in 2027 would be between $98.66 and $100.25. Remember, though, that you won't receive most of that money for years down the road. I therefore calculated the price at which BPT units would have to be trading today in order for an investor to earn a 10% rate of return on his (or her) investment. The answer? Between $56.98 and $57.84 per unit. Under the pessimistic scenario, BPT units are currently about 50% overvalued.
The chart below illustrates the annual distributions that a BPT investor would receive from now until the termination of the trust under the moderate scenario (3.5% annual growth in oil prices, 2.5% annual inflation):
Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 2.5% annually and an assumed increase in oil prices of 3.5% annually through 2037.
Under the moderate scenario, the total distributions paid out between now and the trust's termination in 2036 would be between $147.61 and $153.32. Remember, again, that you won't receive most of that money for years down the road. I therefore calculated the price at which BPT units would have to be trading today in order for an investor to earn a 10% rate of return on his (or her) investment. The answer? Between $69.35 and $70.97 per unit. Under the moderate scenario, BPT units are currently about 38% overvalued.
The chart below illustrates the annual distributions that a BPT investor would receive from now until 2040 under the optimistic scenario (5.0% annual growth in oil prices, 2.5% annual inflation):
Source: BPT annual reports filed with the SEC and author's calculations based on an assumed inflation rate of 2.5% annually and an assumed increase in oil prices of 5.0% annually through 2060.
Under the optimistic scenario, the total distributions paid out between now and the time BP anticipates ceasing production in Prudhoe Bay in 2060 would be between $395.42 and $489.93. It is important to note, though, that you won't receive much of the distributions for 30, 40, or even 50 years from today. I therefore calculated the price at which BPT units would have to be trading today in order for an investor to earn a 10% rate of return on his (or her) investment. The answer? Between $85.13 and $89.15 per unit. Under the moderate scenario, BPT units are currently about 23% overvalued.
How could this possibly be? As you've probably surmised, the limiting factor - the factor that will cause the trust to terminate, at which time the unit price will go to zero - is not reserves. It is not production declines or oil prices. Rather, the culprit is enormous future increases in "Adjusted Chargeable Costs" that are deducted from each barrel of oil produced in the future. These costs are deducted before BPT holders get a single penny in distributions. As these costs increase (and, as we've seen, they will increase rapidly), the amount left over to be paid out to BPT holders will quickly diminish until, ultimately, nothing is left. Even worse, the enormous increases in "Adjusted Chargeable Costs" are contractually fixed and therefore cannot be changed, and practically no amount of oil reserves or increases in oil prices will be enough to overcome them.
And so, after reviewing the results that I've just shared with you, I reluctantly sold all of my units in BPT. Unfortunately, the reality is that BPT may be overvalued by as much as 50%. Considering the facts that (NYSE:I) over the coming years the distributions will fall significantly and eventually be $0 and (ii) eventually the unit price will also go to $0, there is just no way to justify the price at which BPT is currently trading (even, as I've shown, if oil prices soar to $200 per barrel or higher).
So when will BPT investors realize that this is overvalued (at which time, presumably, the price will correct)? My guess is that many retail investors blindly purchase BPT units because (1) it currently pays a high distribution and (2) they have some belief that oil prices will go up in the future and BPT will allow them to reap the rewards of such increases. After all, if the trust were fairly valued as described above, then it would have an enormous yield well in excess of 10%. This would undoubtedly bring in "dividend hunters" as buyers, pushing the price back up. What these investors fail to realize, however, is that a large portion (or, in the case of the "pessimistic" scenario above, virtually ALL) of the distributions paid by BPT are effectively a return of capital and not a distribution at all.
The bottom line: Would you give someone $114 of your money today if they promised to pay you back a total of $100.25 over the course of the next 15 years (but not the original $114 that you paid to them)? If not, and if you believe the "pessimistic" scenario described above best reflects your view of oil prices and inflation in the future, then you might consider looking for investments other than BPT because that is effectively the "bargain" you're striking when you buy BPT at today's prices.
Would you give someone $114 of your money today if they promised to pay you back a total of $153.32 over the course of the next 24 years (but, again, not the original $114 that you paid to them)? If not, and if you believe the "moderate" scenario described above best reflects your view of oil prices and inflation in the future, then you might consider looking for investments other than BPT because that is effectively the "bargain" you're striking when you buy BPT at today's prices. The same holds true for the "optimistic" scenario.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.