A couple of weeks ago, I watched as BP Prudhoe Bay Royalty Trust (NYSE: BPT) dropped from $123 per unit to as low as $105 per unit (intraday) — in only a matter of three trading days. After some searching, it soon became apparent that a negative article on Seeking Alpha written by Tyler Lewis, which you can read here, contributed to the drop. The article, which attempts to quantify what BPT is worth through some well-intentioned but undoubtedly flawed reasoning, pegged the value of BPT at $45.80 per unit. (I’m using the term “unit” instead of “share” because BPT, as a trust and not a company, issues “units” instead of “shares.”)
After reading through the Seeking Alpha article and noticing several large flaws in the author’s analysis, I set out to correct the author’s mistaken assumptions and then run a new analysis of BPT’s true value. (Side note: As an investor in BPT myself, I was irritated that the someone would put a value of $45.80 on each unit of BPT and so was more than happy to put in the work necessary to setting the record straight! I also want to clarify, though, that I thought the article was thought-provoking and provided a much deeper level of analysis than is typically seen in articles of this type. Kudos to Mr. Lewis for that.) This article represents the fruits of my labor, which turned up some surprising conclusions — especially with respect to valuation.
Correcting Mistaken Assumptions
My first step was to fix the mistaken assumptions affecting Mr. Lewis’ conclusions. Below are the four most glaring mistaken assumptions in the author’s valuation analysis, each of which was corrected in my model:
Mistaken assumption #1. Misunderstanding reserves: The author mistakenly claims, “BPT has a set amount of oil in the ground (63 million barrels), and once that oil is gone, the trust dissolves, and a share of BPT stock is worth zero. Zilch. Nada.” The statement that BPT is entitled to only 63 million barrels of oil is false. The 63 million number comes from BPT’s most recently filed annual report, where it was estimated that BPT had approximately 63 million barrels of proved reserves. (For oil newbies, the amount of oil estimated to be in the ground is referred to as “proved reserves.”) However, this is only a guess — and a very unreliable one at that — that can vary wildly over time. The chart below shows the “guess” about BPT’s proved reserves each year since 1994. As you can see, it varies a great deal from year to year and was even “ZERO” in 1998!
As you can see, the trendline (the black line in the chart above) is actually upward sloping, meaning that estimated proved reserves have actually gone UP over time. You might be wondering why the reserves could change so much from year to year. For instance, in 1998 reserves were estimated at ZERO and only one year later they were estimated at almost 100 million barrels! The answer is that the price of oil accounts for virtually all of the variation in proved reserves from year to year. I’m over-simplifying here, but, generally speaking, as long as oil prices go up, so too will BPT’s proved reserves. Take a look at the chart below, which shows the same data as the previous chart — only this time I’ve also graphed the price of oil (represented by the RED line in the chart below).
As you can see, the amount of proved reserves generally increases when the price of oil goes up and decreases when the price of oil goes down. The 63 million barrels number used by Mr. Lewis is based upon $68 WTI oil (the average price of oil in 2009). When BPT’s next annual report comes out in late February or early March, the new reserve estimate will be based upon significantly higher oil prices. I’d be willing to bet a large amount of money that this year’s estimated proved oil reserves will be significantly higher than 63 million barrels.
So how much oil are BPT investors actually entitled to?
The actual amount of oil to which BPT is entitled depends on a lot of factors, but even under reasonable assumptions the amount of proved reserves ultimately attributable to the trust is approximately 100 million barrels. Under an optimistic scenario, that amount increases to approximately 191 million barrels, and under a more pessimistic scenario that amount falls to about 70 million barrels. For more about these three pricing scenarios (“pessimistic,” “moderate,” and “optimistic”) and the assumptions underlying them, see my discussion below regarding future oil prices.
Mistaken assumption #2. Mistakenly assuming that the rate of production decline will be 4% annually, when the data implies that the actual rate will be closer to 2%: For oil newbies, it is important to understand that the amount of oil that comes out of a well each year is not constant; rather, it decreases steadily over time. That fact is not in question; rather, it is Mr. Lewis’ assumed rate of decline (4%) that is too high.
Let’s first take a look at a chart that shows the historical rate of production in Prudhoe Bay since 1987 (the year of the trust’s formation).
It is important to remember that BPT investors are entitled to approximately 16% of the first 90,000 barrels produced each day or, if daily production is less than 90,000 barrels, the actual amount of oil produced. In other words, 90,000 barrels is the “ceiling” for BPT, but it could be (and will be in the future) less than 90,000 barrels. So far, average daily production has only gone below 90,000 once, but anyone can tell that production has been falling quickly and will soon break below 90,000 (likely for good).
What about future production? Mr. Lewis’ article assumed that production would decline at 4% annually, but is that a realistic assumption? According to the data, it is not. The chart below shows estimated future production curves based on 2008 and 2009 production data. The “optimistic” curve is known in the industry as a “harmonic decline curve,” while the “pessimistic” curve is known as an “exponential decline curve.” A harmonic curve is generally used to calculate a “best case” analysis of future production, while an exponential curve is more conservative and often underestimates future production.
What does the chart above mean for BPT investors? Two things. First, it turns out that the production data implies that the rate of production decline going forward will be closer to 2%, not 4%. This means that the amount of oil to which BPT investors are entitled, while decreasing most years, will decrease at a far slower pace than was estimated by Mr. Lewis. Translation: More money in your pocket. Second, while the rate of decline will likely be slower than Mr. Lewis’ projection, BPT investors should note that it is a virtual certainty that average daily production will soon drop below the 90,000 barrel ceiling. Page 23 of BPT’s annual report admits as much, saying, “Production of oil and condensate from the field has been declining during recent years and the decline is expected to continue .” As an investor in BPT, you must understand that the amount of oil that comes out of the ground will generally only decrease from here into the future. Page 19 of the most recent annual report warns investors about this fact, stating, “BP Alaska anticipates that its average net production of oil and condensate allocated to the Trust from proved reserves will be below 90,000 barrels per day on an annual average basis most future years.”
Mistaken assumption #3. Underestimating when the trust will terminate: The author stated that the trust will terminate in 2025. While the actual date on which the trust will terminate depends primarily on where oil prices go in the future, it is possible (though not a certainty) that the trust will last well beyond 2025. Assuming oil prices increase by 2.5% annually (at the time of this writing, WTI oil was at approximately $90 per barrel), distributions will not cease until around 2030 and the trust will not terminate until 2031. If oil prices increase by 3.5% annually, distributions will not cease until around 2035 and the trust will not terminate until 2036. (As a side note, the BPT annual report explicitly states that distributions can never be negative, contrary to what was stated in Mr. Lewis’ article.) Obviously, if oil prices increase at a rate that is slower than 2.5% annually then the life of the trust will be shorter, and if oil prices increase at a rate that is faster than 3.5% annually then the life of the trust will be longer. (Note that these estimates all assume a constant rate of inflation of 2.5% annually.)
For those of you wondering how long oil will continue to be produced out of Prudhoe Bay, page 19 of the BPT annual report provides your answer, stating, “BP Alaska expects continued economic production from the Prudhoe Bay field at a declining rate through 2060.”
Mistaken assumption #4. Not taking into account the effect that higher future oil prices could have on distributions and unit price: The author used the crude oil futures curve to project future prices for West Texas Intermediate crude oil, which I refer to as WTI. (For those not familiar with the futures curve, think of it as the market’s best guess about what oil prices will be each year — 2012, 2013, 2014, etc. – in the future. As of now, the market predicts that the price of oil will generally be higher in the future than it is now, known in the oil markets as “contango.”) Note that, using Mr. Lewis’ approach, oil prices are projected to remain below $100 per barrel until the year 2025. While I agree that this was a perfectly reasonable (though conservative) approach (and not an error), it fails to take into account how the price of BPT would be affected if oil prices increase significantly. I, for one, believe that we will see oil prices in excess of $100 per barrel much sooner than 2025, and so my valuation model takes into account the possibility of oil prices being significantly higher than what the crude oil futures curve implies. If nothing else, these scenarios will demonstrate how BPT’s unit price will be affected by higher future oil prices.
Oil prices used in my valuation analysis
As explained in greater detail below, I ran a valuation of BPT under three scenarios. Each scenario assumed a different annual rate of increase in the price of WTI oil:
- Scenario #1 (“pessimistic”): Low growth in oil prices (2.5% annually)
- Scenario #2 (“moderate”): Moderate growth in oil prices (3.5% annually)
- Scenario #3 (“optimistic”): High growth in oil prices (5% annually)
It is important to note that even my “pessimistic” scenario uses higher prices than those used by Mr. Lewis in his valuation. While I realize that all three of my scenarios use prices higher than the market currently predicts and could turn out to be 100% wrong, I also realize that the market is not always correct, either. These three scenarios represent my own beliefs (and likely the beliefs of many BPT investors) about where oil prices may head in the future. For context, the chart below shows a comparison of the oil prices used by Mr. Lewis in his valuation against the oil prices I used in my valuation scenarios.
The four mistaken assumptions discussed above affect the amount of revenue that will be generated in the future, but before we can do a valuation of BPT we must also examine the costs. Only after costs are deducted do we have an idea about how much money will be left over for BPT investors.
Understanding How BPT is Set Up
Let’s briefly cover how BPT works (Mr. Lewis’ article is largely correct on this subject). As I’m sure you know, BPT is a trust, not a company. It has no employees, and its sole asset is a 16.4246% interest in the lesser of (i) 90,000 barrels per day of crude oil and condensate from Prudhoe Bay or (ii) the actual daily production of crude oil and condensate. BPT investors have no rights to any natural gas that is produced. As Mr. Lewis’ article points out very well, the maximum amount of oil per day to which BPT holders are entitled is 14,782 barrels.
BPT holders are entitled to royalties, which BPT calls the “Per Barrel Royalty,” after certain costs and taxes are deducted. According to the 10-K, “Per Barrel Royalty” is calculated by taking the price of one barrel of WTI crude oil and subtracting (i) “Chargeable Costs” multiplied by the “Cost Adjustment Factor” and (ii) ”Production Taxes.” (As an aside, it is important to note that this formula uses the price of WTI, rather than Brent North Sea crude, to calculate royalties. While the unrest in Egypt has pushed Brent North Sea crude above $100 per barrel, WTI is still trading right around $90 per barrel.)
Think about costs like this: We start with the price of one barrel of WTI oil. We then deduct “Adjusted Chargeable Costs” (described below). The amount remaining after Adjusted Chargeable Costs are deducted is hit with Alaska production taxes (also described below). Whatever is left over is paid straight to BPT investors. For instance, if WTI oil is $100, Adjusted Chargeable Costs are $20, and Alaska production taxes are 40% (these numbers are made up and purely for illustrative purposes), then BPT investors would get $48 (($100 – $20) = $80 – ($80 * 40%)) = $48.
Adjusted Chargeable Costs
Chargeable costs are fixed costs that are deducted before payment of the royalties to which BPT holders are entitled. These charges, which were $14.50 per barrel in 2010, increase each year. By 2020, they’ll be $26.50, and they’ll increase by $2.75 every year thereafter. These increases are legally set in stone and cannot be altered.
But it gets worse. The chargeable costs are multiplied by something called the “Cost Adjustment Factor,” which is essentially an inflation adjustor. This creates a double whammy for BPT investors, as they are hit with both the annual cost increases just described AND an inflation adjustment every single year. The “Cost Adjustment Factor” for the third quarter of 2009 was 1.662, and it will only get higher in the future.
When the “Chargeable Costs” are multiplied by the “Cost Adjustment Factor,” you get a number that BPT calls the “Adjusted Chargeable Costs.” This is the amount of money that comes straight off the top of every barrel of oil produced and decreases the amount of money available for BPT investors. It is an extremely important number for BPT investors to track. Thus far in the trust’s life, the Adjusted Chargeable Costs have generally been far less than the price of a barrel of oil, meaning there is plenty of money left over for BPT investors. In 2009, for instance, the Adjusted Chargeable Costs were about $24.10 per barrel. But as time goes on, these costs will increase drastically. The chart below shows the growth in Adjusted Chargeable Costs from 1991 through the third quarter of 2010. When looking at the chart below, remember that the “Adjusted Chargeable Costs” are deducted before BPT investors are paid a single penny (e.g., if WTI oil is $50 per barrel and Adjusted Chargeable Costs are $40, then there is only $10 per barrel left over for BPT investors). If oil prices do not increase by at least as much as Adjusted Chargeable Costs increase, then BPT investors will receive a smaller per barrel royalty.
Clearly, Adjusted Chargeable Costs have gone nowhere but upward since 1991. The bad news for BPT investors is that this upward trend will not only continue but also accelerate drastically in the future. The chart below shows both historical Adjusted Chargeable Costs that were presented in the chart above and projected future Adjusted Chargeable Costs based on an assumed long-term rate of inflation of 2.5%.
As you can see in the chart above, Adjusted Chargeable Costs are increasing at a very high rate. At some point, Adjusted Chargeable Costs will get so high that they will exceed the price of a barrel of WTI oil. When that happens, there will be no money left over to pay to BPT investors. The trust will terminate, and BPT will truly be worth “zero. Zilch. Zero.”
The charts below illustrate when Adjusted Chargeable Costs will become greater than the price of oil, at which time the BPT trust will terminate, under each of the three valuation scenarios I used in my analysis. As a reminder, below are the three valuation 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%)
Pessimistic Scenario
The chart below shows how the rapidly increasing Adjusted Chargeable Costs eat into the amount of money left over for BPT investors. The blue line represents future oil prices, the red line represents Adjusted Chargeable Costs, and the green line, which is the most important line, represents the amount of money per barrel of oil that is left over for BPT investors.
As you can see, Adjusted Chargeable Costs are the enemy of BPT investors. Under the “pessimistic” scenario, the trust would have no money left over to pay investors starting in 2026 (see the green bar in the chart above for the amount per barrel that is left over for investors). Pursuant to its terms, the trust will terminate after paying no distributions (or very low distributions) for two years in a row. Therefore, the trust would therefore terminate at the end of 2027 in my “pessimistic” scenario.
Moderate Scenario
The chart below illustrates the point at which Adjusted Chargeable Costs will surpass the price of a barrel of WTI oil, leaving nothing left for BPT investors, under the “moderate” scenario.
The first thing that you probably noticed is that, under the moderate scenario, the trust pays distributions until 2034 (look at the green bar), which is obviously a good thing for BPT investors. However, beginning in 2035 distributions are negative, and the trust would terminate at the end of 2036. The second thing you should notice is that Adjusted Chargeable Costs increase at a rate that is FAR in excess of the increase in oil prices. Ironically, under the moderate scenario the trust stops paying distributions in the same year that oil prices break about $200 per barrel in 2035! This is an extremely important concept for BPT investors to understand — even if oil prices rise a great deal in the future, it does not necessarily mean that BPT investors will reap the rewards from such increases. Buyer beware.
Optimistic Scenario
The chart below illustrates the point at which Adjusted Chargeable Costs will surpass the price of a barrel of WTI oil, leaving nothing left for BPT investors, under the “optimistic” scenario.
It is only in the “optimistic” scenario, in which we’ve assumed that oil prices will skyrocket by 5% each and every year, that we finally see the amount left over for BPT investors (the green bar) holding constant. Even the most bullish of oil investors would consider it unlikely that we’ll ever see these oil prices. Notice that the optimistic scenario assumes oil prices will hit $150 per barrel in 10 years and will hit $250 per barrel in 21 years. The odds that actual prices ever hit these assumed levels seems extremely low to me. Regardless, notice that even though oil is skyrocketing in price, the amount per barrel that is left for BPT investors stays relatively constant (the green bar). Think about what this means: Even if oil goes from $200 to $300 in only nine years, BPT investors do not see their distribution increase at all. In other words, all of the gains from increased oil prices are eaten up by increases in Adjusted Chargeable Costs.
Production Taxes
Any amount that is left over after deducting “Adjusted Chargeable Costs” is subject to production taxes levied by the state of Alaska. The actual rate of the tax depends on oil prices, but it can be as high as 50% so these are significant and are reflected in the valuation analysis presented below.
Termination
At some point, the BPT trust will terminate. According to the trust’s governing documents, the trust will terminate when the total annual amount of distributions paid out by the trust is less than $1 million per year for two straight years.
When the trust terminates, Mr. Lewis is correct; it will be “worth zero. Zilch. Nada.” It is a certainty that at some point in the future, the value of each unit of BPT will be $0. However, between now and the time the trust terminates, BPT investors are able to collect lots of large quarterly distributions. And that is the real question: What is the present value of the future distributions that will be paid out by BPT between now and the time that the trust terminates?
Valuation Results
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.
Pessimistic scenario
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):
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.
Moderate scenario
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):
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.
Optimistic scenario
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):
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 (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.