Have you been buying during this market decline and need a good short? Oh yes, we all do. Let’s try this: Would you buy shares in an oil company trading at 13x forward FCF, with production declining 3-5%/year, no capital spending on exploration and thus near zero reserve replacement? I didn’t think so. I am recommending a short sale of Permian Basin Royalty Trust (NYSE: PBT), which is trading as though oil & gas are priced at $100/barrel and $11/mcf when in fact they are trading at $65, and $7 respectively. I think oil will stay under $75 until the catalyst (dividend cuts), and you’ll do fine with all the cheap things you own elsewhere on a relative basis. However, if you are concerned about oil and gas bouncing, I recommend a long position in a far cheaper, similar upstream producer. For example, take a look at Oxy trading at 7-8x forward discretionary cash with better reserves and growth potential and a solid chemicals biz.
Permian Basin Royalty Trust (NYSE:PBT) owns a net overriding royalty interests in the famous Permian Basin (Waddell Ranch), and a group of properties scattered around the rest of the Republic of Texas (Texas Royalty properties). The Trust was created in 1980 in an attempt to finance development of said oil assets, by giving investors an opportunity to participate directly in the project economics, without having to worry about the re-investment of the cash flow into other projects. The trust has no employees and simply receives monthly checks from the field operators, which are then distributed to shareholders, and taxed as ordinary income, minus a small depreciation credit at the individual level. Hence, it is a classic pass-thru entity that trades on the NYSE.
Structure of the Royalty arrangements:
Royalty income consists of the amounts of hydrocarbons sold by the field operators burdened by the net overriding royalty interests (Royalties) due to the trust from the sale of said production less accrued production costs, development and drilling costs, applicable taxes, operating charges, and other costs and deductions multiplied by 75% in the case of the Waddell Ranch properties and 95% in the case of the Texas Royalty properties. Or put mathematically:
Well Head Revenues – Excise & Property Taxes – Operating Costs – CapX = Net FCF
Unit Holder Royalties = 75% * Net FCF.
Royalties are taxable to the holder at the income tax rate, as the IRS considers PBT a passive entity that just collects the checks, and the unit holder is considered a business entity. Hence you too can be an oil company by just buying units of PBT! There is a small depletion/depreciation tax credit, but b/c the properties are mature and the book cost basis is so low its negligible.
Built-in Terminal Declines: The 2 royalty properties are now in terminal decline (water-flooding), with oil production rates declining 3-5%/year and gas remaining steady for now (but declines will begin soon and be sharper as the field managers are spending little on capx). For example, 2007 CapX for Waddell Ranch was only ~$6/barrel of production (and less than $1/proved boe), which largely includes the costs of work-overs and a handful of infill wells drilled (10 wells). The field managers of Waddell planned to 2x that in this year but so far CapX is running at only $3 mil annualized compared, to $11 mil last year. Looks like they abandoned further drilling.
Take a look at my graph of oil production for Waddell Ranch in Culbertson County, TX. Declines like these are not reversible, especially with so little capital investment. In fact the decline rates were double digits in the years after the oil bust of 1998, when CapX was cut to nil. The drilling programs from 2002-2007 helped initially lift production, but now we have returned to a 3-5% decline rate, which will accelerate now that all drilling activity has ceased. The situation with the Texas Royalty Properties is similar.. You can’t fight geology, and the lack of drilling when prices were north of $90 suggests that there is nothing left to do in Culbertson County. Oxy on the other hand is projecting 5-8% production growth for several years.
Misleading Accounting (Rising Prices Masking Declines): If you look at the monthly releases for PBT, it suggests that production is going up, as royalties net to the trust are rising. This has to do with the silly way that the trust reports. You see, being a ‘royalty trust’ they report net royalties ‘in-kind.’ Net of what? Net of the amounts of hydrocarbons needed to be sold at market to cover the field operator’s expenses and capital expenditures. In 2008, UNDERLYING production is falling, but the price of oil & gas was up, whilst the cost of lifting a barrel of oil remained steady at around $8/bbl. Thus, if 10 boe is produced and sold for $80/bbl, the royalty paid to the trust would be reported as 9 boe, as 1 boe would be sold to cover opex. However, if you double the price of oil to $160 and ran the same math, only ½ of a bbl of oil would need to be sold to cover opex, so royalties to the trust would be reported as 9.5 boe even though underlying production remained the same. In the case of PBT, oil production on the underlying properties is down ~4% so far in 2008, while prices were up, and CapX was down. Thus, it appears as though production is growing, but in reality you are just witnessing the phenomenon known as operating leverage.
This same phenomenon exists when the trust reports its reserves in its annual 10K, as remaining reserve estimates appear to be rising sharply. The petroleum engineer uses underlying production and a future price assumption based on year end strips, to calculate how many boe of hydrocarbons must be sold to cover costs, and then reports how many boe is due to the trust in total over the remaining life of the fields. Therefore, the number 1 driver for year-to-year reserve ‘revisions’ is the increase/decrease in the prices of oil and gas. Extensions and discoveries are much smaller: these are mature fields being water flooded. Its very evident if you pull the K’s from ’01, where reserves were written down dramatically with the fall of oil and gas prices during the last recession.
Valuation: On a trailing basis PBT is trading for a 11.7% yield or roughly 8.5x distributed earnings. Of course this distribution is largely taxable as OI, and is not directly comparable to a company like Oxy trading a 5x trailing fully taxed eps, which as a shareholder you pay 15% on the ultimate dividends and capital gains. Nonetheless, those earnings were for prices of oil above $100 and natural gas above $10. In the current regime of $65 oil and $7 gas, PBT is trading for ~13x taxable distributions (7.7% yield) and Oxy for ~8x earnings. PBT is way over valued.
Don’t take my word for it; let’s pull the PV10 valuation from the independent reservoir engineers. Using a 10% discount rate, the Dec 31. ’07 reserve balances and oil and gas prices of $100 and $10 respectively, the independent petroleum engineers value PBT’s royalty interests at ~$450 mil. Using today’s oil and gas prices would yield a PV10 value of about $300 mil ($9.60,/share, $6.40/share respectively). But who cares what some ‘experts’ think, you want to know what doobadoo thinks, right?
I’ll go ahead and play petrochemical engineer banker and do my own valuation of PBTs assets, eh? Using a light discount rate of 8.5%, and assuming cost inflation of 3%, $65 oil, $7 gas, and low single digits declines I get a valuation of ~$11/unit for PBT. You can view my DCF of the DCF tab of my posted spread-sheet.
Catalyst: Dividend Cuts:
It will take about 2 months for the current pricing environment to flow through to the dividend, as production and royalty distributions trail by a few months. I am projecting $.13/share dividend at current oil & gas prices. If you are concerned about oil & gas spiking I recommend buying some Occidental Petroleum, as 2/3 of their upstream comes from the Permian Basin (same as PBT.) In fact, Oxy’s properties in the Permian are located a stone’s throw to the north of Culbertson County. Oxy is cheap on an upstream basis, and it looks like you get the chemicals biz for nearly nothing. But then again there are plenty of cheap things to buy. I think you can just short PBT, and call it a year.