|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
|Subject||Re: I'll Take Some Of That|
|Entry||01/08/2019 01:35 PM|
I'll jump in and share my work. Here is my table - I assume 2% inflation, G&A costs of 1.2 million per year, and flat oil price decks at the stated levels.
These numbers are for 2019 and beyond (excludes the $1.00 distribution announced last week). The four far right columns are calculated as distribution divided by stock price ($27).
Formula is = (Assumed Oil Price - Adjusted Chargeable Costs - (Assumed Oil Price * Production Taxes) ) * Average Daily Production * Days of Production * Royalty % Share = Distributable Cash before G&A
Back out G&A and then divide by 21.4 million units.
The main driver of value is WTI and then rate of inflation. If you have an opinion on those two variables then you can get a good idea of what the total distributions will be for the remainder of the life of the trust.
Why would BP buyout the units unless it was economic for them to do so? As is the stock is pricing in ~$85-90 average oil prices into perpertuity on an undiscounted basis. Cable lays out the dissolution of the trust in his write up.
As to what breaks the stock? Time.
|Subject||Re: Re: I'll Take Some Of That|
|Entry||01/08/2019 03:20 PM|
Thanks for sharing your model. Unless WTI comes back, I think this breaks sooner rather than later. BPT earned about $18.50 per barrel in Q4. The increase in chargeable costs in 2019 will reduce profitability by ~7.50 per barrel. WTI averaged just under $60 in the quarter. If WTI stays at current levels of around $50, BPT's profitabilty per barrel is reduced by another $10 to roughly $1. That gets me to a distribution of less than $0.10 for Q1.
|Subject||Royalty Interest Termination|
|Entry||01/08/2019 03:43 PM|
cable or TallGuy:
Very interesting read. I have a technical question after reading the 10K.
It is obvious that the TRUST will terminate and liquidate if there are two years of revenue < $1mm.
But have you read the Royalty Interest Agreement to see if it is also worthless at that point in time? In other words, does the Royalty Interest Agreement also terminate if there are two years of revenue < $1mm?
There is a troubling passage in the 10-K:
"If BP Alaska does not exercise its option, the Trustee will sell the Trust property on terms and conditions approved by the vote of holders of 60% of the outstanding Units . . . "
This is bizarre: so the Trust terminates automatically due to two years < $1mm, but a vote of unitholders is required to actually sell the property. What property? All it has is cash and this Royalty Interest. Why would a vote be needed unless the Royalty Interest still has option value? And what happens if unit holders say "no"?
Another troubling passage:
"Unit holders do not have the right under the Trust Agreement to seek or secure any partition or distribution of the Royalty Interest or any other asset of the Trust or any accounting during the term of the Trust or during any period of liquidation and winding up."
Why would a unitholder seek a partition of the Royalty Interest after Termination unless the Royalty Interest still has option value?
So the quesiton is whether you have read the Royalty Interest and whether it is possible that the Royalty Interest is a perpetual option that a third party could purchase even after trust terminates.
You seem to be assuming that the Royalty Interest Agreement "knocks out" after 2 years < $1mm because the Trust terminates, but I am not sure of that after reading the 10-k.
|Subject||Re: Royalty Interest Termination|
|Entry||01/08/2019 04:38 PM|
From my reading I think you are right that it is possible the interest could be sold or otherwise have its perpetual option-value accrue to the unit-holders even after 2 years of <$1mm but I think the reality is the dynamics aren't in place for the unit-holders to receive meaningful option value:
BP gets an option to buy this at the lower of (i) the value arrived at by a 3rd party valuation analysis [IBank or other qualified institution] or (ii) the current trading price.
First, I suspect the 3rd party valuation experts are going to have a much stronger incentive to please BP (who can do more business with them in the future) than to fight for every last $ of value for trust-holders (who almost certainly won't).
Second, I don’t think there’s much option value in any event. Two years from now, if the trust were to terminate, the breakeven price would be ~$60 WTI and that would be rising by ~$5.50 + the annual change in CPI + the change in production taxes (which, based on historic #’s, pretty rapidly get into the $20/bbl range).
Making some estimates as to these breakeven prices (similar to what TallGuy presented) and using call options with strikes at those levels I can see the optionality being some ~$75m (stopping at 2025 because, after that point, the breakevens require such high oil prices we have no idea what the production tax should look like based on historical results and it seems hard to imagine ascribing a great deal of value to these levels given the implied call option valuations):
Note though that:
Including the pending ~$1 dividend, if BPT got what I think is substantially overstated credit for its option value (~$80m) the company would still be worth <20% of its current trading price. This assumes that (i) BP doesn’t abuse the repurchase process (ii) that the company isn’t forced to liquidate in a fire sale because it might be at risk of losing BNY and (iii) that shareholders haven't become despondent causing this thing to trade below fair value [in which case BP can simply buy it on the cheap] - all 3 of which would, presumably, represent worse outcomes than the ~$80m.
|Subject||Re: Re: Royalty Interest Termination|
|Entry||01/08/2019 04:55 PM|
After posting that I was able to find the 2023+ options. Adding in the 2019 and 2020 call values total value here would be ~$200m or <40% of the current market value (including the pending $1 dividend) if these were real calls but, as discussed, for several reasons they aren't and are worth less than standard calls:
Note: Some call values have changed slightly - I was using December prices but changed this to June to more accurately reflect the FY value.
|Subject||Re: Re: Re: Royalty Interest Termination|
|Entry||01/08/2019 05:22 PM|
I ran similar #s. Not sure what inflation you are using. And I agree with your analysis.
I also agree that no one is going to pay the Black-Scholes Fair Value for this perpetual strip of quarterly calls.
And I basically get $5-ish of "theoretical" value assuming oil stays at $50 for 2018-2019 and Trust terminates. I think you get $4.
|Subject||Re: Royalty Trust Borrow Rates|
|Entry||01/09/2019 11:29 AM|
If there is one desk on a trading floor I wouldn't trust, it would be the stock loan desk.
Look to the options market to get an idea of the real cost of borrowing/lending, but if you're retail, good luck getting anything close to that. IB takes a 50% cut and that's about the best you can do. Otherwise try to press the stock loan group. No stock should ever be -15%/+GC. Might have just been right before ex-div date for that one name
|Subject||Re: Re: Re: Re: Re: Royalty Interest Termination|
|Entry||01/10/2019 03:56 PM|
On the borrow - you should check again after the next dividend is paid. People call in their stock around the div date (which should be in about a week or so) for tax reasons (lower rate on dividend from the company as compared to from the short seller). Availability disappears and rates spike. I saw a borrow rate chart showing it in the 20% range the rest of the time.
I think the assumption of flat production is just people being conservative. That's why I've assumed it - I don't have a strong view either way. I'm inclined to think down is more likely given the nature of oil production, the age of the field, and the current price of oil.
|Subject||Re: Re: Re: Re: Re: Re: Royalty Interest Termination|
|Entry||01/10/2019 10:27 PM|
I am not questioning your assertion that the borrow rate drops after the dividend, but if you own stock and you broker lends it out, you are still paid the dividend and if you are short you are liable for the dividend, so I don't see why the borrow rate should change based on the dividend date.
|Subject||Re: Re: Re: Re: Re: Re: Re: Royalty Interest Termination|
|Entry||01/10/2019 10:58 PM|
Light hit the nail on the head but I can elaborate. (This is from a US investor perspective in a US equity) When you are long the stock and the company pays a div, that div is taxed at the favorable dividend tax rate. When you are long but your broker is leding out your share, the short seller pays a payment to the broker for the amount of a dividend and the broker then pays you that amount. But this is not a bona fide dividend!! It is a payment from a broker to you and classified as ordinary income, usually subject to higher tax rates. So the smart investor will pull their shares right before the dividend to ensure they get the tax advantaged payment.
Going even further, most retail brokerages don't even lend out shares over ex-dates becuase they don't want to screw mom and pop unknowingly on a dividend payment tax issue. There is a thing known as a "gross-up" that some brokers will charge the short seller over the dividend ex-date to try and account for the tax hit the lender will take but it is variable and nowhere near standard practice. The easier thing to do is for the broker to pull the shares and not entertain this risk.
Large players quoting the street for shorts might only see availability in BPT at a bunch of retail brokerages like Schwab and TD if it's primarily retail who owns it. As mentioned a few times here, this is a retail hotel which gives the inital opportunity, but seeing those lenders means you pretty much KNOW that borrow is going to be pulled from you right before the ex-date. Most of the retail brokerages just pull the shares so they don't get involved in the tax mess. That's why availability dries up and the rate spikes.
As a supplement, the rate spiking on the remaining available shares can also serve as an "effective gross-up" for the lender who takes that tax hit. Hope this helps explain it.
|Subject||Re: Re: Re: Re: Re: Re: Re: Re: Royalty Interest Termination|
|Entry||01/11/2019 12:30 AM|
PCM - thanks very much for that explanation.