|Shares Out. (in M):||21||P/E||3.8||0|
|Market Cap (in $M):||420||P/FCF||3.8||0|
|Net Debt (in $M):||0||EBIT||109||0|
|Borrow Cost:||Tight 15-50% cost|
BP Prudhoe Bay Royalty Trust (BPT) is a royalty trust that has been written up before by Reaper666 in 2014 but I think several developments have made the short more compelling and actionable today than ever. Given the recent plunge in WTI, BPT is standing at the edge of a cliff where it is likely that BPT will make a final distribution in January 2019 of about $1.00/unit with no distributions for a while thereafter or even indefinitely. With the stair-step-up in costs as defined by the trust agreement, even the option value on BPT is diminished significantly unless we are back in a $70+ WTI world. The writings on the wall are so clear that even the trustee has opted to increase cash reserves to cover the administrative expenses of the trust, which I will elaborate upon later.
The exact mechanics of BPT’s cash flow can be easily understood and modeled with just a simple read-through of the 10-K but a quick summary is as follows. BPT is a trust that receives royalty payments based on 16% of production from an oil producing field in Alaska’s Prudhoe Bay, operated by BP up to 90mbbl/d (i.e., 90mbbl/d or less). The trust agreement also determines royalty payments based on WTI prices less a fixed per barrel cost (“Chargeable Costs”) multiplied by a “Cost Adjustment Factor” that inflates with US CPI. Production Tax is also deducted from that calculation. The preceding formula will determine royalty payments to the trust, who will deduct actual administrative expenses and payout the remainder to shareholders. A quick illustration of the recent $1.4076 distribution is below:
Some important things to note are:
This is not a traditional oil and gas mineral that receives royalty checks with little expenses – this is a trust that has very defined calculations to determine royalty payments according to the trust agreement.
The chargeable costs are fixed amounts as stipulated by the trust agreement, not actual cash costs, hence any service cost deflation does not benefit the trust. Those costs escalate every calendar year per the table on page 7 of the most recent 10K. I have also provided a table later on.
The Trust will terminate upon a vote of Trust unit holders or if revenues are less than $1 million per year for two successive years.
The trustee maintains a cash reserve of about $1 million to cover trust expenses in the event that royalty revenues do not cover trust expenses. The trustee has the right to alter the cash reserve by drawing from distributions. The following is an excerpt from the 10K.
“Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust.”
“In order to ensure the Trust has the ability to pay future expenses, the Trust established a cash reserve account which the Trustee believes is sufficient to pay approximately one year’s current and expected liabilities and expenses of the Trust.”
Why Is BPT Overvalued and Why Now?
BPT has a historical dividend yield of 28% and I think that there are many investors who are unaware of the cost mechanics of the royalty calculation and are also unaware of the crude leverage that BPT has.
Chargeable costs were $20/bbl in 2018 and steps up to $23.75 in 2019 and $26.50 in 2020 and the current adjustment factor is around 1.95. That means that the breakeven WTI price for BPT before production taxes and trust expenses will be $46/bbl in 2019 and $52/bbl in 2020, stepping up from $39/bbl in 2018.
At current strip pricing of $48/bbl in 2019, BPT will not generate any royalty revenue to distribute in 2019. Which means assuming strip prices hold, BPT will pay a distribution in January 2019 for 4Q18 and is unlikely to pay a distribution thereafter. Even if WTI were to recover to $55 into perpetuity, BPT would pay a $1.50/unit distribution in 2019 and nothing in 2020. At $60 into perpetuity, BPT would distribute $2.70 in 2019, $1.00 in 2020 and zero thereafter ($3.70 undiscounted fundamental value). At $70, it would be $4.40/$2.80/$1.30 in 2019-2021 and zero thereafter. ($8.50 undiscounted fundamental value).
Historically, there was some option value in holding BPT for a recovery in WTI, which often explained the premium BPT received relative to the fundamental value of future distributions. However, the option value is significantly diminished from here on out because the annual step-up on costs substantially increases the strike price each year. That slope picked up significantly in 2018 but BPT was bailed out by WTI in the summer. However, in 2019 and beyond, the option strike price step-ups will continue as chargeable costs step-up as shown in the table below. I have assumed a 1.95 flat adjustment factor in 2019 and beyond for illustrative purposes but it will inflate with US CPI. The step-up in chargeable costs will continue at $2.75 per year after 2020 into perpetuity.
I think the old mentality of holding BPT for option value while clipping a very high yield is misleading investors into thinking there is fundamental and option value there.
Even the Trustee is concerned about future cashflows such that they (BNY Mellon Trust Company) announced today, that they intend to withhold more cash above trust expenses from the January 2019 distribution onwards to build a cash reserve of $1.27 million presumably to cover the trust expenses. For reference, trust expenses run about $1.3 million per year (link to press release below).
The assets themselves are also declining and that has been evident in the recent production history. The last time BPT produced over 90mbbl/d for a quarter was in 1Q17 and has averaged below that level since. BPT explains the decline in production in the 10K.
“BP Alaska has undertaken a program of field-wide infrastructure renewal, pipeline replacement, and mechanical improvements to wells. As a consequence of these activities and their required downtime, and the natural production declines discussed above under “Historical Production,” BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis in 2015, 2016 and 2017. 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. The occurrence of major gas sales could accelerate the decline in net production, due to the consequent decline in reservoir pressure.”
In summary, BPT is trading significantly above it’s fundamental value of future distributions, even when considering a reasonable option premium. The production base is declining and the break-even WTI price steps-up significantly every year. The pure fundamental valuation depends on the price of WTI which is $1.50 at current strip, $3.70 at $60 WTI and $8.50 at $70 WTI. I will not go into option valuation but I do not believe that option value in BPT is worth $10-$15/unit.
Crude Macro View
I would be remiss to pitch BPT as a short without a crude view so I wanted to lay out a short and succinct opinion. I think the global economy is in a late-cycle stage and deceleration of demand globally is evident across all sectors (company guidance, earnings misses, economic data). The recent China trade war actions have exacerbated the problem and the Fed decision today will not help either. The OPEC meeting from November left the crude market with little conviction that supply/demand will be balanced despite their cuts and that is evidenced by the decline in short- and long-dated futures. 2018 has also shown the market that WTI in the high $60s will likely lead to too much US shale growth.
US inventories have missed expectations in the last few months and times spreads for both WTI and Brent are negative, which are both strong bear indicators. This time around, it is not just a supply problem but a demand problem as well. I think WTI remains in the $50s for 2019 and we have already seen several sell-side analysts revise their price decks into the $50s with more likely to come.
What will force the market to realize the fundamental mis-match in BPT’s valuation? I am estimating a $1.00 distribution in January 2019, a 30% decline from the previous distribution and quite possibly the last distribution for a long time or indefinitely, which would prompt current holders to re-assess the fundamental value of their holdings. If not, with the 10K filing in February 2019, there will be an auditor report on remaining reserves at BPT and I also expect there to be some warnings about future distributions in the risk factors section. Lastly, if low WTI prices persist, it is quite likely that BPT will make no distribution in April 2019 and will force yield investors to question the fundamental value of the stock.
BPT is a volatile stock and has traded significantly above fundamental value before driven by stubborn or uninformed investors (mostly retail) who think BPT is a proxy for crude prices and during periods of short covering. There is also a high cost to borrow but there are many ways to structure a trade via options that would significantly reduce the risk.
There is also a potential risk of a short cover ahead of a distribution announcement as stock holders call back their stock on loan. However, I think the risk-reward is easily defined when a yield stock may ultimately stop paying a dividend.
The biggest fundamental risk to the short is if WTI recovers back to the $60s, but some possible hedges are real E&P mineral companies with sustainable 8-10%+ FCF yields like FLMN and VNOM who have no escalating cost provisions and are true perpetual royalties. An alternative hedging strategy are out of the money USO call options.
30% decline to January 2019 distribution
Filing of 10K in February 2019
Likely deminimus or zero distribution in April 2019